IAI SA7-0525

INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

May 2025

SA7 - Investment and Finance

Time allowed: 3 Hours 15 Minutes
Total Marks: 100

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Q. 1) You are the Investment actuary of ABC Life Insurance Co., a large Indian life insurer writing a mix
of with-profit (participating) policies, non-participating guaranteed plans, unit-linked insurance plans
(ULIPs), and annuity contracts. The company’s investment portfolio is currently allocated chiefly to
government bonds and high-grade corporate bonds, with a smaller equity portfolio supporting the
with-profit fund. The economic environment is challenging: inflation has been persistently high and
interest rates have been rising. The Insurance Regulatory and Development Authority of India (IRDAI)
is introducing a new Risk-Based Capital (RBC) framework next year, which is expected to significantly
increase the capital required for riskier assets. ABC Life’s latest solvency ratio under the current rules
is adequate but only marginally above the required minimum. Preliminary RBC calculations indicate a
potential capital shortfall if the investment strategy remains unchanged.

The Chief Financial Officer (CFO) is concerned about the company’s capital position and is exploring
ways to strengthen it. One option under consideration is raising additional capital – either by issuing
new equity or by raising subordinated debt – to meet the RBC requirements and support future
growth. Meanwhile, the Chief Investment Officer (CIO) argues that the company can improve its
solvency and profitability by adjusting its investment mix. The CIO proposes allocating a greater
portion of the portfolio to higher-yielding assets such as lower-rated corporate bonds, infrastructure
debt funds, real estate, and equity, within the limits allowed by IRDAI regulations (for example, the
limits on ‘Other Investments’). The CIO believes this could boost investment returns and thereby
improve surplus over time. In contrast, the Chief Risk Officer and the CFO worry that increasing asset
risk could jeopardize the company’s ability to meet the guaranteed liabilities, especially under the
upcoming RBC regime which assigns high capital charges to equities and other high-risk assets. They
suggest that a better approach is to de-risk the portfolio: increase the matching of assets to liabilities
(for example, investing more in long-term government bonds or using derivatives to hedge
guarantees), in order to stabilize solvency.

The Board has asked you, as the investment actuary, to analyse these issues and advise on a suitable
course of action. Answer the following questions based on the scenario above:

i) Product Liability Characteristics: Identify the four main product groups written by ABC Life
mentioned above, and briefly describe one key investment characteristic or requirement for each.
(5)
ii) Impact of Inflation and Interest Rates: Explain how the current environment of high inflation and
rising interest rates can affect ABC Life’s assets and liabilities. What implications do these economic
factors have for the insurer’s investment strategy and ability to meet policyholder expectations?
(5)

iii) Capital Raising Options: The CFO is considering raising additional capital to improve ABC Life’s
solvency under the RBC framework. Compare the merits of raising new equity capital versus issuing
subordinated debt from the insurer’s perspective. In your answer, discuss how each option might
impact the company’s balance sheet, cost of capital, control/dilution, and financial flexibility. (8)

iv) Higher-Yield Investment Strategy: The CIO proposes to invest a greater portion of the portfolio in
higher-yielding instruments (such as lower-rated corporate bonds, infrastructure assets, and
equities) to boost returns. Discuss the advantages and risks of this strategy for ABC Life. In your
answer, consider factors such as potential investment income vs. asset quality, liquidity, regulatory
investment limits, and the effect of the new RBC capital charges. (10)

v) De-risking and Asset–Liability Matching: An alternative approach is to de-risk the portfolio by

increasing asset–liability matching and hedging. Discuss the potential benefits and drawbacks of
shifting towards a more conservative investment strategy (for example, holding more long-term
government bonds or using derivatives to hedge guarantees) in the context of ABC Life’s situation.
Consider the impact on solvency volatility, guarantee security, long-term returns, and any practical
or regulatory constraints. (7)

vi) Recommendation: Given the trade-offs identified above, recommend an overall investment and
financing strategy for ABC Life. Your answer should outline a coherent plan that balances the need
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to improve returns and solvency with prudent risk control. Justify how your recommended strategy
would meet the company’s obligations to policyholders (including guarantees) while satisfying
regulatory requirements (such as the RBC constraints). (15)
[50 Marks]

Q.2) You are the chief investment officer (CIO) at ABC Asset Management Company (AMC), managing
a range of investment funds catering to both retail and institutional investors in India. The
macroeconomic environment is experiencing significant stress:

• Global trade tensions and a shift towards protectionist trade policies in the U.S. are impacting
capital flows.
• Domestic institutional investors (DIIs) are facing challenges due to demographic shifts,
particularly an aging population, affecting their capital generation abilities.
• The Indian stock market is highly volatile, particularly in the Financial Services and Information
Technology (IT) sectors, while regulatory changes are influencing portfolio strategies.

ABC AMC holds a USD-denominated bond portfolio worth $250 million and you are tasked with
assessing the risks and recommending a strategy to mitigate the impacts of these macroeconomic and
regulatory factors.

Today’s spot rate is ₹ 85 = US $ 1.

i) Global Trade Tensions and the USD/INR Exchange Rate

• Explain how global trade tensions and the U.S.'s protectionist stance may impact the USD/INR
exchange rate and capital flows into India. How might these factors affect FII inflows into the
Indian equity market? (10)

ii) Impact of INR Depreciation on the Bond Portfolio

• Estimate the impact of a 6% appreciation or 6 % depreciation of INR on the value of ABC AMC’s
USD-denominated bond portfolio worth $250 million in INR term.
• What actions can the AMC take to hedge this currency risk?
(7)
iii) Tactical Rebalancing in Response to Sector-Specific Risk

• Given the current portfolio allocation (40% Financial Services, 20% IT, 15% Consumer Goods,
15% Healthcare, 10% Energy), if the Financial Services sector is expected to decline by 12%,
estimate the overall portfolio loss and recommend a tactical rebalancing strategy to mitigate
this risk. (8)
[25 Marks]

Regulatory Considerations:

• SEBI's Liquidity Management Norms: Ensure that the AMC adheres to SEBI’s regulations on
liquidity, especially when rebalancing the portfolio.
• RBI’s Foreign Investment Guidelines: Monitor how changes in FDI and FPI regulations may
affect capital flows and market performance.

Q.3) You are an investment consultant advising the Trustees of a large, mature Defined Benefit (DB)
Exempt Provident Fund Trust in India, regulated implicitly under EPF & MP Act guidelines and Trustee
responsibilities. The scheme is closed to new entrants and future accrual. Its funding level on an
actuarial basis is 105%, but the Trustees are concerned about managing assets against liabilities to
ensure benefit security, especially given the prevailing interest rate environment in India and the
increasing pensioner proportion. The scheme currently holds 60% in Indian equities (mix of large and
mid-cap) and 40% in a mix of Indian Government Securities (G-Secs) and high-rated PSU/Corporate

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Bonds. The sponsoring employer's covenant is considered reasonably strong but not guaranteed
indefinitely.

Prepare a report to the Trustees advising on a revised investment strategy. Your report should:

i) Analyse the key objectives and constraints for the scheme's investment strategy at its current
stage of maturity, considering the Indian regulatory environment for such trusts. Critically
evaluate the relevance of the sponsor covenant strength in setting the strategy. (6)

ii) Explain the principles of Liability-Driven Investment (LDI). Discuss the suitability of different
LDI implementation approaches (e.g., using physical Indian bonds like G-Secs/SDLs vs.
synthetic replication using derivatives like Overnight Index Swaps referencing
MIBOR/Modified-MIBOR or INR Interest Rate Swaps) for this scheme, including the
operational considerations of using derivatives within the Indian context. (8)

iii) Recommend a revised Strategic Asset Allocation (SAA), justifying your choices for both the
matching and growth portfolios, suitable for the Indian market. Discuss the rationale for
including specific Indian asset classes beyond traditional G-Secs and equities (e.g., AAA/AA
corporate bonds, Infrastructure Investment Trusts (InvITs), potentially Alternative Investment
Funds (AIFs) within regulatory limits) and the risks they introduce. (7)

iv) Outline the key governance considerations and processes the Trustees should have in place
to effectively oversee the implementation and ongoing management of the revised strategy,
including monitoring LDI effectiveness and manager performance within the Indian
governance framework for trusts. (4)
[25 Marks]

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INSTITUTE OF ACTUARIES OF
INDIA

EXAMINATIONS

SA7 – Investment and Finance

May 2025

INDICATIVE SOLUTION

Introduction
The indicative solution has been written by the Examiners with the aim of helping candidates.
The solutions given are only indicative. It is realized that there could be other points as valid
answers and examiner have given credit for any alternative approach or interpretation which
they consider to be reasonable.

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IAI SA7-0525

Q. 1) Topic: Investment Management, Capital Management, and Investment Strategy (Risk-Based

Capital, Asset-Liability Matching)

i) Product Liability Characteristics

Syllabus Topic: Meeting investor requirements, including investment strategies to meet liabilities.
• With-Profit Policies (Participating Business): These policies promise bonuses that depend on
investment returns. Investment characteristics include a balanced mix of low-risk bonds and
higher-risk equities to generate returns while ensuring sufficient capital to meet policyholder
guarantees.
• Non-Profit Policies: Typically, these policies involve fixed premiums and benefits. Investment
characteristics focus on low-risk investments (such as government bonds) to match the
predictable liabilities.
• Unit-Linked Policies (ULIPs): These are investment-linked insurance products where
policyholders bear the investment risk. The asset mix depends on the investor’s choice but
should include equities, bonds, and other instruments for potential growth.
• Annuity Contracts: These guarantee regular income for policyholders, so the investment
strategy is designed to match long-term liabilities with low-risk bonds, minimizing exposure
to market volatility.
(5)
ii) Impact of Inflation and Interest Rates
Syllabus Topic: The framework for investment management, including corporate finance principles.
• Impact on Liabilities: Inflation increases the present value of liabilities, especially for products
like annuities with inflation-linked payouts. Rising interest rates may increase the cost of
managing long-term liabilities.
• Impact on Assets: Inflation reduces the real return on fixed-income assets, while rising rates
can lead to price declines in long-duration bonds.
• Solvency Concerns: The company’s solvency could be at risk if the liabilities increase faster
than assets, especially if investments are mainly in fixed-income assets.
• Investment Strategy: Higher interest rates could make government bonds more attractive but
may hurt long-term growth if equity allocations are reduced.
• Policy‑holder expectations: Participating and ULIP customers expect competitive returns;
failing to match peer performance risks lapses and reputational damage.
(5)

iii) Capital Raising Options

Syllabus Topic: The framework for investment management, with an emphasis on corporate finance.
• New Equity Capital:
o Merits:
1. Directly boosts capital to meet RBC requirements.
2. Improves solvency and provides financial stability.
3. No repayment obligations compared to debt.
o Demerits:
1. Dilution of ownership and control.
2. Potentially lowers earnings per share (EPS) due to increased share count.
3. May negatively affect stock price if market perceives dilution negatively.
• Subordinated Debt:
o Merits:
1. Lower cost of capital than equity.
2. No dilution of ownership or control.
3. May provide tax benefits since interest payments are tax-deductible.
o Demerits:
1. Repayment obligations and interest expenses.
2. Increases leverage and financial risk.
3. May be difficult to issue if market conditions are poor.
(8)

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iv) Higher-Yield Investment Strategy

Syllabus Topic: Management and risk control for an investment manager, including portfolio
management.
• Advantages:
1. Higher Returns: Potential for higher long-term returns through risky assets like
equities and high-yield bonds.
2. Increased Surplus: Higher returns lead to greater surplus, which can be used for
policyholder bonuses or capital growth.
3. Capital Diversification: Increases portfolio diversification by including more asset
classes.
4. Inflation Hedge: Equities and infrastructure assets often outperform in inflationary
environments.
5. Liquidity for Growth: Offers liquidity to take advantage of growth opportunities.
6. Regulatory Arbitrage: Can potentially improve risk-based capital by allocating to
assets that are less capital-intensive under RBC.
7. higher expected return, diversification, potential inflation hedge, opportunity to buy
mis-priced credit, tactical use of IRDAI “Other-Investments” bucket.

• Risks:
1. Higher Capital Charges: The RBC framework assigns higher capital requirements to
riskier assets like equities and lower-rated bonds.
2. Volatility: Greater asset volatility increases the risk of not meeting policyholder
guarantees.
3. Liquidity Risk: Riskier assets like private equity or real estate can have lower liquidity,
posing risks during market stress.
4. Market Risk: Increased exposure to market downturns can significantly affect the
company’s financial stability.
5. Risk to Policyholder Expectations: If riskier investments underperform, it could lead
to lower than expected returns for policyholders, damaging the company’s
reputation.
6. credit‑risk (default and downgrade), higher RBC charges (e.g. 17 %–22 % for listed
equity, 12 %‑15 % for BB/BBB credit), liquidity risk for real estate/infra funds,
concentration limits (e.g. 15 % per issuer group, 10 % unlisted equity), governance
capacity, pro‑cyclicality.
(10)

v) De-risking and Asset–Liability Matching

Syllabus Topic: Meeting investor requirements and risk management strategies.
• Advantages of De-risking:
1. Guarantee Security: Ensures that the portfolio can meet future liability payments,
especially for guaranteed products.
2. Solvency Stability: Reduced volatility in the asset portfolio leads to greater solvency
stability.
3. Interest Rate Matching: Long-term bonds match the duration of liabilities, helping to
mitigate interest rate risk.
4. Regulatory Compliance: Aligns with regulatory requirements for matching assets and
liabilities.
5. Reduced Market Sensitivity: Less exposure to equity markets lowers the likelihood of
capital shortfalls during market downturns.
• Drawbacks of De-risking:
1. Lower Returns: The portfolio may generate lower returns, especially if government
bonds underperform.
2. Potential Missed Opportunities: A conservative strategy may miss higher returns from
growth assets.
3. Capital Inefficiency: Holding low-yielding bonds could be less efficient from a capital
perspective under the RBC framework.
(7)
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vi) Recommendation
Syllabus Topic: Solving problems related to overall financial management of portfolios.
Strategic overview. ABC Life should pursue a dual‑track approach: (a) shore up regulatory capital
ahead of the 2026 RBC go‑live, and (b) pivot the asset mix so that guaranteed liabilities are tightly
hedged while surplus assets continue to earn a competitive return for participating and ULIP
policy‑holders.

Raise hybrid capital. Issue INR‑denominated Tier II subordinated debt up to 25 % of available capital
and launch a rights‑issue for any residual gap so that post‑issue coverage sits at least 300 bps above
the projected RBC minimum.

Optimise cost of capital. Debt coupons are tax‑deductible and avoid ownership dilution; the equity
tranche is deliberately modest to protect earnings per share while still signalling commitment to
solvency.
Segregate the portfolio into two buckets. A guarantee‑backing portfolio covers with‑profit guarantees
and annuities, while a surplus‑growth portfolio supports bonuses and ULIP fund choices.

Guarantee‑backing asset mix. Allocate 80 % to long‑dated G‑Secs/SDL STRIPS, 15 % to AAA PSU bonds
and 5 % to payer swaptions that cap reinvestment risk if yields fall.

Ensure duration and cash‑flow matching. The weighted‑average duration of backing assets should be
within ±0.5 years of liability duration; cash‑flow testing confirms 95 % of benefits are covered by
contractual coupons.

Surplus‑growth asset mix. Invest 45 % in diversified equities (20 % global ETFs to reduce home bias),
25 % in infrastructure debt funds/InvITs, 10 % in REITs and 20 % in high‑grade corporate bonds that
carry lower RBC charges than equities.

Inflation resilience. Within the equity sleeve, tilt 10 % towards consumer‑staples and energy
companies that historically outperform during persistent inflation.

Dynamic rebalancing triggers. If RBC coverage falls below 155 %, automatically shift 5 % of risky assets
into long bonds; when coverage exceeds 175 %, reverse the move. This rules‑based overlay keeps
solvency volatility in check.

Liquidity management. Maintain a 5 % buffer in T‑Bills and triparty repos to fund derivative margin
or meet large ULIP switches within T+1.

Currency and rate hedging toolkit. Use INR interest‑rate swaps to fine‑tune duration, swaptions for
tail protection and USD/INR forwards to neutralise any overseas equity exposure.

Robust credit‑risk governance. Set single‑issuer limits at 2 % of portfolio market value and ensure
aggregate exposure to BBB credit stays below 10 %, comfortably within IRDAI ‘Other‑Investments’
caps.

Comprehensive stress testing. Perform quarterly RBC‑consistent shocks – e.g., 200 bps parallel yield
shift, 30 % equity fall and BBB‑to‑BB downgrades – and escalate breaches to the Board Risk
Committee.

Transparent policy‑holder communication. Update the bonus philosophy and ULIP fund literature so
that customers understand the new mix and its risk/return implications, thereby managing lapse risk.

Operational readiness. Upgrade middle‑office systems for daily RBC monitoring, collateral calls and
covenant reporting on the Tier II debt; provide staff training on the new workflows.

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Annual strategic review clause. Commit to a full ALM and capital review every year, or ad‑hoc if the
10‑year G‑Sec yield moves by more than 75 bps in a single quarter, ensuring the strategy remains fit
for purpose.

By combining fresh hybrid capital with a disciplined, liability‑aware asset strategy, ABC Life can
comfortably exceed the forthcoming RBC hurdle, safeguard guarantees and still generate the
investment upside that policy‑holders expect.
(15)
[50 Marks]

Q. 2)
i) Global Trade Tensions and the USD/INR Exchange Rate
Syllabus Reference: The framework for investment management, including global influences on capital
markets.

Exchange-rate pressure from global trade frictions

1. Safe-haven dollar demand – Tariffs and “on-shoring” rhetoric prompt global investors to buy
USD assets; INR tends to weaken or stay volatile.
2. Wider Indian trade deficit – Costlier imported inputs (oil, electronics) enlarge the
current-account gap, adding structural INR pressure.
3. Higher U.S. real yields – Fed policy encourages EM outflows into Treasuries; passive
global-bond funds trim India allocations.
4. Risk-off sentiment – EM equity funds reduce gross exposure; India sees episodic FII pull-outs
when VIX spikes.
5. Swap-hedge costs rise – Wider USD funding spreads lift the cost of rupee hedges; this lowers
India’s risk-adjusted equity appeal.
6. Sector effects – Export-heavy IT stocks may benefit from INR weakness, but Financials suffer
as wholesale-funding costs jump.
7. Regulatory frictions – Stricter FPI KYC/UBO rules slow approval pipelines; some offshore funds
hold back.
8. Bond-index offset – Prospective inclusion of India in global bond indices could partly counter
equity outflows, but timing is uncertain.
9. RBI intervention limits – Spot and forward-book sales can smooth, not reverse, INR moves;
large FPI exits still move the tape.
10. Net result – Wider USD/INR trading band, thinner FII flows, and a higher equity-risk premium
for India
(10)

ii) Impact of INR Depreciation on the Bond Portfolio

Syllabus Reference: Investment strategies to meet liabilities and risk control for investment
managers.

Currency risk on the USD bond portfolio

A. INR valuation impact
Scenario FX rate (₹/US $) Portfolio value (₹ bn) Change vs base
Today 85.00 21.25 –
INR appreciates 6 % 79.90 19.98 - 1.27 bn
INR depreciates 6 % 90.10 22.53 + 1.28 bn
(US $ 250 m × FX ÷ 1,000)

B. Two hedging actions

Hedge One key benefit One key drawback
Negative carry when INR forward
Rolling 3-month Low-cost, linear hedge; easy to size
premium is wide; frequent rollover
USD/INR forwards exactly to bond principal & coupons
risk

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Hedge One key benefit One key drawback

12-month USD put / Caps downside but keeps upside if INR Premium outlay; option market depth
INR call options depreciates less than expected thin for sizes > $1 bn
(7)

iii) Tactical Rebalancing in Response to Sector-Specific Risk

Syllabus Reference: Management and risk control for investment managers, including portfolio
management.
. Loss estimate
40 % × (‑12 %) = ‑4.8 % hit to the total equity sleeve.

B.
Set a 5 % NAV draw‑down trigger and pre‑clear the action list with the Investment Committee.
Pre‑defined governance avoids ad‑hoc decisions under stress.

Use sector‑index futures (short NIFTY‑Bank) or total‑return swaps to obtain instant Financials‑beta
reduction while cash trades are scheduled.
Derivative overlay slashes exposure on day 1 without large‑block selling.

Phase down the Financials cash weight from 40 % to 25 % via (Volume-Weighted Average Price
algorithms and crossing networks minimises market‑impact and brokerage.

Stagger sales over multiple tax years or utilise index‑future “rolls” to defer crystallising capital‑gains
tax on the legacy book.

Redeploy 10 % into Consumer‑Staples ETFs and 5 % into Healthcare stocks with low earnings cyclicality
defensive tilt dampens portfolio volatility.

Fund 1 %–2 % of notional in 3‑month NIFTY‑50 put spreads to cap downside through the execution
window
option premium is a known, limited cost.

Maintain liquidity buffers: post‑trade, hold ≥ 10 % of AUM in cash/T‑Bills and ensure any single‑day
turnover ≤ 20 % of 30‑day ADTV, meeting SEBI’s liquidity‑risk guidelines.

Track total transaction cost (brokerage + bid‑ask + slippage) and keep it below 40 bps round‑trip;
back‑test VaR and Stress VaR daily to confirm the new mix stays within the fund’s 95 % VaR ceiling.
(8)
[25 Marks]

Q.3)
i) Relevant Syllabus Objectives:
• Primary: 2.1, 2.1.1 (specifically for Indian Pension Fund context), 3.1.5, 3.1.3, 3.1.4, 4.1 series.
• Secondary: 1.1 (Indian assets/derivatives), 1.2 (Indian economic/market influences 1 ), 1.3
(Indian legislative/regulatory framework 2), 3.2.1/3.2.2.

Objectives, Constraints, and Sponsor Covenant

• Objectives:
o Primary Objective: Ensure all member benefits are paid securely as they fall due
o Achieve this with a very high degree of certainty
o Maintain stability in the funding level on the actuarial basis
o Minimise the risk of deficits emerging in the fund
o Adhere to regulatory guidelines for Exempt PF Trusts in India
o Fulfil fiduciary duties under the Indian Trusts Act, 1882
• Constraints:
o Liability Profile: Mature, closed scheme dictates focus on pensioners/deferreds

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o Liability Profile: Liabilities likely long-duration, requiring long-term asset matching

o Regulatory Investment Pattern: Need to operate within permissible investment
patterns (implicit or explicit) for Indian PF trusts
o Liquidity Needs: Must hold sufficient liquid assets for benefit outgo
o Indian Market Context: Prevailing G-Sec yields & availability of specific bonds
constrain matching
• Sponsor Covenant Relevance:
o Provides a backstop against deficits, influencing risk capacity
o However, for a mature scheme, focus remains on asset-liability matching, reducing
reliance on the covenant over time
(6)

ii) LDI Principles and Implementation Approaches

• LDI Principles:
o Manage assets relative to liabilities, not just asset benchmarks
o Aim to reduce funding ratio volatility
o Match asset sensitivity to liability sensitivity for key risks
o Key risks for this Indian trust: Indian interest rates (G-Sec curve)
o Key risks: Relevant Indian inflation measures
• Implementation: Physical Bonds:
o Mechanism: Buy physical Indian bonds (G-Secs, SDLs, Corp Bonds)
o Mechanism: Match bond cash flows/duration to liabilities
o Pros: Transparent and conceptually simple
o Pros: Directly holds income-generating assets
o Cons: Perfect matching is difficult due to bond availability
o Cons: Can be capital intensive to achieve high duration
• Implementation: Synthetic Replication (Derivatives):
o Mechanism: Use derivatives like INR Interest Rate Swaps (IRS)
o Mechanism: Receive fixed / pay float to increase asset duration synthetically
o Pros: Capital efficient for adjusting risk exposures
o Cons: Introduces counterparty credit risk
o Cons: Requires operational capability for collateral management (8)

iii) Revised SAA Recommendation

• Rationale: Current 60% equity is too high for a mature, closed Indian PF trust need to shift
significantly towards matching assets
• Matching Portfolio (Target 75-85%):
o Core Bonds (50-60%): Primarily G-Secs and SDLs
o Core Bonds: Include high-quality (AAA/AA) Indian PSU/Corporate bonds for yield
o LDI Derivatives Overlay: Use INR IRS to fine-tune duration hedge if needed
o Cashflow Matching Credit (5-10%): Consider Indian InvITs for long-term cash flows
o Cashflow Matching Credit: Requires due diligence due to complexity/liquidity risk
• Growth Portfolio (Target 15-25%):
o Indian Equities (10-15%): Significantly reduce; focus on diversified large-caps
o Indian Equities: Consider using low-cost Index Funds/ETFs
o Other Diversifiers (5-10%): Maybe REITs or suitable multi-asset funds available in India
o Other Diversifiers: AIFs likely face stricter regulatory/governance hurdles for PF trusts
• Justification: Reduces equity risk, increases liability hedge ratio balances security with modest
growth potential within Indian market context introduces manageable credit/liquidity risk via
non-G-Sec matching assets
(7)

iv) Governance Considerations

• Need a clear, updated Investment Policy Statement (IPS)
• IPS should detail objectives, SAA, risk tolerance, LDI approach
• Ensure Trustees have necessary expertise or access to advice
• Provide regular training for Trustees on investment/LDI strategy
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• Implement robust manager selection and monitoring processes

• Mandates must align with IPS; monitor performance and risk controls
• Maintain an integrated risk management framework
• Regular, clear reporting to Trustees on performance, risk, and compliance
(4)
[25 Marks]

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INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

21st November 2024

SA7 - Investment and Finance

Time allowed: 3 Hours 15 Minutes
Total Marks: 100
IAI SA7-1124

Q. 1) Pension fund industry has seen Contributory Pension Schemes (CPSs) replacing majority
of the erstwhile Defined Benefit Schemes (DBSs) owing to

• increasing fiscal burden of DBSs on governments

• increasing insolvencies of other employers; key reason being deficits in DBSs

People are concerned with CPSs’ uncertainty of returns / benefits when compared to DBSs.
To promote participation from more people in the CPSs, Pension regulators want to allow
some kind of investment guarantee in CPSs. Investment guarantee will be offered through
new CPSs by Pension Fund Management Companies (PFMCs) with approval from Pension
regulator after assessing the risks and risk mitigation measures. With introduction of
investment guarantees, obligations of PFMCs increases, hence Pension regulators now need
to enhance monitoring mechanisms. PFMCs are required to regularly submit reports on the
guaranteed CPSs.

i. Describe various types of investment guarantees that could be offered in CPSs. (4)

ii. Describe key issues in a guaranteed CPS where ALM (Asset Liability Management)
analysis is required. (13)

iii. Describe common risks faced by any PFMC. (6)

iv. Discuss plausible risks faced by various stakeholders in guaranteed CPSs. (7)

v. Suggest ways to control the risks identified in part (iv). (5)

vi. List possible indicative reports / statements to be prepared by PFMCs at different

frequencies required by Pension Regulations. (15)
[50]

Q. 2) You joined a start-up DEF fund house three years ago as assistant fund manager. Your two
tactical strategies: Covered Call (CC) and Protective Put (PP) using exchange traded
derivatives have played a key role in growth of business. In CC, an investor can increase
the income of their fund by writing call options on the assets held. In PP, an investor buys
put options on assets held to protect against fall in their market value.

Recently DEF has acquired a thirty year old PQR fund house. You have now become a
Deputy CIO (Chief Investment Officer) of the combined entity DEFPQR. The core strategy
of both DEF and PQR fund houses was to “Buy and Hold” well researched stocks (equities)
for their HNW (High Net Worth) clients. Variable (performance related) pay was given to
fund managers who beat their respective sector / factor index set as benchmarks.

Average Age of Overall Salary cost split

Fund
Fund Managers
House Fixed Variable
in years
DEF 25 80% 20%
PQR 55 60% 40%

CIO asked you to conduct a training session for fund managers of both DEF and PQR. You
will give a presentation about planning and implementing a tactical strategy CC / PP
depending upon the research team’s short term view on stocks held.

i. Describe the key points you would include in your presentation for the training session. (7)

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After the presentation, DEF fund managers agreed to use the tactical strategies but most of
PQR fund managers were reluctant to use covered call. Listening to their concerns you
suggested a way (without using derivatives) to enhance portfolio returns.

ii. Discuss possible reasons: why DEF fund managers agreed and PQR fund managers were
reluctant to use covered call. (4)

iii. Explain one way (without using derivatives) to enhance portfolio returns. (2)

Chief Marketing Officer has approached you and CIO to discuss rising popularity of the
following:

• Sustainable investing with special focus on EV (Electric Vehicles) stocks;

• Smart beta investing; and
• Some exchanges offering derivatives on crypto currencies to reduce tax burden of
dealing directly in crypto currencies

iv. Discuss the prospects of EV industry in India by considering the following:

• Factors affecting recent high sales growth rate
• Challenges for future growth rate
• Possible solutions to tackle the challenges (12)

v. Explain smart beta investing. (4)

vi. Discuss a method to create and maintain benchmark index for smart beta investment funds.
To illustrate the methodology, you may consider investible universe of stocks from BSE500
index and an example of smart beta fund as Alpha 30 fund. (6)

vii. Describe a merit and the demerits of crypto currency investing in India. (7)

viii. Discuss the usefulness of some exchanges claiming to reduce tax burden by offering
derivatives on crypto currencies. (3)

Your research team is analysing XYZ exchange traded fund benchmarked to Nifty 50.
XYZ’s weekly natural log returns for last five financial years are summarized below:

Percentile Log Returns Percentile Log Returns

0.0 -13.5% 75.0 1.7%
1.0 -6.5% 95.0 3.6%
2.5 -4.7% 97.5 4.5%
5.0 -3.5% 99.0 6.4%
25.0 -0.8% 100.0 10.6%
Mean 0.31% Standard Deviation 2.43%

ix. For INR 10 lakhs invested in XYZ,

• give two estimates of 95% one week VaR (Value-at-Risk); and

• give an estimate of 95% one year VaR (5)
[50]
************************

Page 3 of 3
 INSTITUTE OF ACTUARIES OF INDIA

Subject SA7 - Investment and Finance

November 2024 Examination

INDICATIVE SOLUTION

Introduction
The indicative solution has been written by the Examiners with the aim of helping candidates. The
solutions given are only indicative. It is realized that there could be other points as valid answers and
examiner have given credit for any alternative approach or interpretation which they consider to be
reasonable.
IAI SA7-1124

Solution 1)
i. Types of investment guarantees:
• Guaranteed Vesting Benefit (GVB) in nominal terms: Vesting Benefit (VB) at the time of
retirement is determined using Guaranteed Growth Rate (GGR) of X% say 7% on the
contributions made by a subscriber during accumulation phase. This is equivalent to DBS.
VB = GVB.

• GVB in real terms: similar to GVB in nominal terms but GGR is Y% + inflation index
returns say 1% + inflation rate.

• Minimum Absolute Return (MAR): All contributions grow at MAR to give GVB. MAR
could be 0% (=capital guarantee) or MAR>0% say 3%. VB at retirement is higher of
Actual Fund Value (AFV) and GVB;
VB = Max (GVB, AFV).

Shortfall = Max (GVB - AFV, 0) and surplus = Max (AFV - GVB, 0); Actual returns
under MAR depends on actual fund performance. Any shortfall is made good by sponsor
/ PFMC or both in agreed proportion. Any surplus is credited to subscriber’s account.

• Minimum Relative Return (MRR): similar to MAR, but contributions grow at returns
linked to Government Bond (GB) yields.
For example, MRR = X% GB yield say 50% of one year GB yield; or
MRR = GB yield – Y%, say ten year GB yield – 1.5%.

• The above guarantees could be applicable only on retirement (terminal) or on an on-going

basis i.e. on death/ transfer/ partial withdrawals/ retirement.
On-going guarantee is more onerous.

• Another guarantee could be offered by a tie-up of PFMC with Annuity-Service-Provider

(ASP) where ASP offers guaranteed annuity option i.e. the minimum rate of converting a
lump sum in to annuity. [4]

ii.
Issues where ALM analysis is required

What kind of guarantee: absolute or relative rate of return guarantees can be reasonably
provided by a PFMC given its capital and economic environment

Optimal guarantee reset period (Quarterly / half yearly /annual) that strikes a balance between
subscriber interest and PFMC who offers a guaranteed CPS

Determine optimal asset allocation to money market instruments, GBs, Corporate debt and
equity; can be done in following ways:
• Using Cash flow allocation strategy: Set allocation proportions of new contributions
and asset income cash flows like coupons / redemptions due to maturities etc.
• Using Target allocation strategy: Rebalance portfolio at desired frequency as per
target proportions to various asset classes
• Using Life cycle strategy: Rebalance portfolio at target proportions dependent on age
of the subscriber; choice of investment option aggressive/ moderate/ conservative and
term remaining to retirement.

Market consistent Valuation of the assets and liabilities of PFMC offering investment
guarantees

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IAI SA7-1124

Regular ALM reports on status of guarantees: whether guarantee is in-the-money i.e. it is

biting or out-of-the –money

Stress testing / scenario analysis to assess level of shortfall is within tolerable limits

Stress testing / scenario analysis for individual guaranteed CPS’s capital assessments and
transfers / reflection of liabilities

Assessing solvency Capital / risk based capital requirement for PFMC and the ongoing need
for capital for all CPSs offered with or without guarantees.

Determine methods and appropriate bases for assessing the on-going solvency of PFMC,
considering the capital requirements

Set a basis for measuring and monitoring key metrics through ALM analyses, including
stochastic approaches, for management of guaranteed CPSs

Set metrics for internal controls and procedures necessary to run and implement investment
guarantees and enable PFMC in proper financial reporting

Develop appropriate ALM models for guaranteed CPS to determine

• Cost of Guarantees (CoG) offered
• Investment Guarantee Charge (IGC): fee /charged for the guarantee offered.
• Investment Guarantee Reserve (IGR): amount set aside as reserves to meet future
expected shortfalls
• For on-going guarantees, on valuation basis, set floor to IGR = Max (current short
fall, previous IGR with interest + current IGC)

Managing terminal guarantees is relatively simple but for on-going guarantees, determine:
• waiting period for the guarantees to be applicable like 3/5/7/10 years, if a waiting
period is required
• minimum target allocation to stable assets (e.g. >70%) like money market
instruments/ bonds
• cap on target allocation to volatile assets in aggregate (e.g. <30%) like equities, real
estate
• exit loads/ penalty with respect to Market Value Adjustment (MVA) for pre-
retirement exits other than death like transfers / partial withdrawals

For ASPs offering guaranteed annuity option,

• determine the minimum guaranteed rate of converting a lump sum in to annuity
• develop appropriate hedging strategies to mitigate risks
[13]

iii. Common risks faced by a PFMC:

Market risk is the risk relating to changes in the value of the portfolio due to movements in
the market value of the assets held. It can be measured / monitored using Value at Risk.

Credit risk is the risk that counterparties to an agreement will be unable or unwilling to fulfill
their obligations. It can be measured / monitored using credit scores or ratings.

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IAI SA7-1124

Liquidity risk is the risk of not having sufficient cash to meet operational needs at all times.
Identifying and measuring liquidity risk include the cash budgeting / short-term financial
planning techniques, gap analysis and duration analysis.

Operational risk is the risk of loss due to fraud or mismanagement within the organisation;
failed or inadequate people, processes or systems and external events. It is difficult to quantify
this risk.

Relative performance risk is the risk of under-performing comparable PFMCs. This risk can
be reduced by mimicking the competitors’ actions but it is hard to find the required
information on time to do so.

Product / business risk: Contributions / charges collected from subscribers are not sufficient
to cover the product development and other regular expenses due to more than expected
expense inflation and / or lower than expected sales volume.

Cyber risk: Risk of clients’ data breaches / theft due to cyber crimes like ransom-ware attacks.
This risk can be controlled by investing in technology architecture with firewalls and anti-
virus or anti-malware software.

Regulatory / compliance risk: Non-compliance of existing and new regulations may lead to
heavy penalties or closure to new business or even cancellation of licences to do business.
This risk can be controlled by having a dedicated compliance team closely monitoring the
developments in regulations. [6]

iv.
Stakeholders in a CPS are:
• PFMC
• Sponsor
• Subscribers
o Opting guaranteed CPS
o Opting non-guaranteed CPS
• ASP
• Government / Regulators

PFMC primarily faces market risk depending on the value of fund of guaranteed CPS
changing adversely against its liabilities.

Sponsors also face market risk while paying / sharing the burden of shortfalls from terminal
and on-going guarantees.

PFMC bears liquidity and market risk for on-going guarantees from subscribers’:
• Partial withdrawals;
• Death; and
• Transfers.
Under extreme market scenarios shortfalls are huge and probability of withdrawals / transfers
increases due to subscribers’ anti-selection against PFMC.

For subscribers opting guaranteed CPS, returns may be lower than those not opting guarantees
to the extent of IGC paid.

PFMC faces operational risks in maintaining books of accounts and needs to comply with the
Pension Regulations on monitoring status of guarantees etc.; non-compliance may attract
penalties.

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IAI SA7-1124

Where a PFMC manages both guaranteed and non-guaranteed CPSs, there is a risk for
subscribers opting not-guaranteed CPS that PFMC would do internal fund transfers of
deteriorating risky illiquid assets (like equities during recession) from the guaranteed CPS
funds to not-guaranteed CPS funds in exchange for fixed income assets.

Internal fund transfers are done at current market prices for controlling shortfalls in
guaranteed CPS funds up to the extent target asset allocation of non-guaranteed CPS funds
allow. This will result in increasing the market risk that is fully borne by the subscribers
opting not-guaranteed CPSs.

ASP that offered guaranteed annuity option faces market risk when interest rates are low,
expense inflation risk and longevity risk.

Regulators will be concerned of leaving loop holes in preparing or implementing regulations [7]
that PFMC could take advantage leading to loss for some subscribers.

v. PFMC can control market risk by regular ALM modelling and reporting shortfalls i.e.
difference between market values of the CPS funds against the GVB.

If it seems that IGR will not be sufficient in future then propose capital injections in advance
to the board/ senior management and also to the sponsors for sharing shortfalls.

PFMC should avoid offering on-going guarantees and offer only terminal guarantees to
reduce liquidity and market risks arising from anti-selection of subscribers.

PFMC can control operational risks by establishing appropriate internal reporting and by
separation of front office and back office functions. Also establish clearly the roles and
responsibilities of each employee.

A subscriber should choose a PFMC that charge low rates as IGC.

Regulators could prescribe regulation on limiting internal fund transfers between guaranteed
and non-guaranteed funds. Till then...
... a person should avoid subscribing to non-guaranteed CPS with a PFMC that also offers
guaranteed CPS...
...if it is unavoidable (when all PFMCs started offering both) then select a PFMC that offers
very small/ basic guarantees like capital guarantee.

ASP could purchase:

• swaptions to mitigate market risk;
• longevity swaps to mitigate longevity risk; and
• real estate/ equities or index linked bonds to mitigate expense inflation risk. [5]

vi.
Possible indicative reports

PFMC should develop interface to provide relevant reports to various stakeholders like
subscribers, sponsors, Banks, Custodians, and Regulators etc

Daily Report on:

• Net fund receipt for CPSs
• Investment report on purchases
• Discrepancy/confirmation report on net payout
• Report of CPS wise payout position
• Redemption report on sales
Page 5 of 13
IAI SA7-1124

• Net Asset Values (NAVs)

• Investment management fees charged to CPSs
Monthly Reports on:
• Reconciliation of AUM and Units
• Details of Portfolio for CPSs being managed by PFMC
• Statement of Purchases and Sales effected by PFMC
• Fund Inflows and Outflows of CPSs being managed by PFMC
• Report on transactions in securities of Group Company/ PFMC associates
• Statement of downgraded investments held
• Statement of investments classified as default
• Statement of exposure limits for CPSs being managed by PFMC
• Statement of investments not eligible for investment management fees

Quarterly Reports on:

• Report transactions in securities by key personnel of PFMC in their own name
• Report transactions in securities with any of PFMC's associates
• Overview of portfolio positioning including evaluation of
o Current economic conditions
o Prospects for securities markets
o Justification for the positions and transactions in the portfolio
o Attribution of performance over last quarter (and year when applicable) on
absolute basis as well as relative to the specific benchmark
o Outlook for returns for the portfolio
• Report on status of investment guarantees
o Statement on amount of Investment guarantee reserves (IGR) held
o Statement on amount of current shortfall
o Statement on amount of investment guarantee charges (IGC) collected

Half-yearly Reports on:

• Copy of half yearly unaudited accounts of CPSs as per CPS accounting regulations
• Any change in interests of Directors

Annual Reports on:

• Sponsor’s regulatory licenses status and details of any changes in name or
capitalization of PFMC or Sponsor(s)
• Statement showing the amount of interest accrued but not realized
• All service contracts executed by PFMC, including outsourced activity
• All service contracts such as for custody arrangements and transfer agency of the
securities are executed in the interest of subscribers
• Summary of all activities and compliance with regulations, guidelines, circulars
• Copy of the Audited Annual Report and other information including details of
investments as per the CPSs accounting regulations
• Copy of unaudited provisional financial statements (Balance Sheet, Revenue Account,
notes and schedules of each CPS
• Voting Report including the number of votes cast (for, against, or abstained)
• Statement of whether PFMC has complied with its obligation to exercise its voting
rights in subscriber’s interests only
• Statement on amount of shortfall covered / realized
• Statement of IGR > IGC
• Report on stress test to check IGR is sufficient to meet stressed shortfall

Ad-hoc Reports on:

Page 6 of 13
IAI SA7-1124

• Bio-data of all its Directors along with their interest in other companies within few
days of their appointment
• Conflicts of interest
• Any other information as determined by the Regulator [15]
[50 Marks]

Solution 2:
i. Long term investors in stocks employing buy and hold strategy could enhance returns by
applying tactical strategies like Covered Call (CC) and Protective Put (PP) using exchange
traded European-style options. Both CC/PP can affect the holding period of a stock for tax
purposes. Exercising them could attract capital gains tax.

PP requires two-part forecast. First, long term forecast must be bullish for buying (or holding)
the stock. Second, short-term forecast is bearish for buying put option to limit risk.

Suppose a downward trending stock is believed to reverse upward. Applying PP is

advantageous than using stop-loss order while acquiring the stock to limit risk if the predicted
change in trend does not occur…
…as a stop-loss order is price sensitive and usually get triggered by a sharp fluctuation in the
stock price before reversing trend. Long put is limited by time, not stock price.

Apply PP before earnings report of a stock held that could send stock price sharply in either
direction. Investor will benefit if the report is positive, and it limits risk of a negative report.

Irrespective of the view, it is desirable to hedge the stock held partly or fully by purchasing
PP, as views may go wrong and stock may crash any time...
…and if stock price rises, the investor participates fully, less insurance cost of PP.

Delta of stock plus put portfolio in 1:1 ratio is always positive since delta of stock = 1 and -
1< delta of put < 0. If view on the stock is highly bearish then hedge fully (portfolio delta say
-0.1 to 0.1) otherwise hedge partly (portfolio delta say 0.4 to 0.8).

Purchase the far dated put options and roll over before one or two months remaining to expiry.
This will avoid losses from theta decay that will be severe when closer to the expiry date.

If a particular stock put options are not available for trading or thinly traded with huge bid-
offer spreads, then consider hedging using sector or market index put options… …with
appropriate hedge ratio considering beta of the stock.

When stock price falls, use the proceeds from PP to purchase more of the stock at lower levels
provided the stock’s fundamentals are still good…
…otherwise switch over to another best stock suggested by research team.

Roll over the PP at close to expiry of put options for desired level of hedging (delta) to hold
the stock going forward…
…especially for ITM (In-the-money) puts to avoid crystallization of capital gains tax.

While selling call options in CC, pick near expiry since theta decay will favour most.

As long as stock price remains below strike price, a rolling CC will keep on generating regular
premium income to enhance portfolio return.

If stock price rises above strike price by expiry, any upside above strike price is lost and
capital gains tax will be crystallized…
…hence do not apply CC in the planning stage if view on the stock is highly bullish.
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IAI SA7-1124

Close the CC already in-force even for loss at implementing stage if view on the stock turns
to highly bullish…
…and consider CC again only after the momentum has halted.

Apply CC with strike price above few strikes of the target price by expiry i.e. at:
• deep OTM (Out-of-the-money) if view is mildly bullish to neutral
• OTM but closer to ATM (At-the-money) if view is mildly bearish to neutral.

Roll over the CC if at close to expiry call option becomes ITM and view is intact to avoid
crystallization of capital gains tax.

While rolling over ITM CC ensure credit i.e. slide up the strike price of CC subject to Sale
price of next month call-option > purchase price of expiring ITM call option.

Close the CC to book profits if call option has lost most of its value say 80% or 90% during
any time within expiry…
…and roll over CC provided the view is intact.

An upward trending stock is believed to reverse downward in some near future. Applying CC
is advantageous than using limit order when waiting for its price to rise to a certain
threshold…
…as CC ensures selling at target price similar to a limit order but with extra income of
premium. [7]

ii. PQR fund managers’ significant portion of salary (variable salary 40%) is dependent on
meeting the benchmark…
…and CC may sometimes underperform simple buy and hold strategy when CC expires in
deep ITM...
…whereas for DEF managers variable salary at stake is 20%.

Even if CC expires slightly in ITM, the stock delivery will attract huge capital gains tax at
inappropriate time…
…disturbing the tax plan for PQR clients as their stock holding periods can be as long as 30
years…
…whereas for DEF clients capital gains would be relatively low as maximum holding period
is three years.

Majority of stocks held by PQR might be small / mid-cap stocks not in FnO (Future and
Options) segment so cannot use exchange traded derivatives for CC…
…but could use PP for partial hedging through index put options.

DEF fund managers might have agreed due to over enthusiasm of trading in derivatives as
they are young with average age 25 years…
…whereas PQR fund managers were reluctant to use covered call may be due to lack of
enthusiasm as they are old with average age 55 years. [4]

iii. Long term investors in stocks employing buy and hold strategy could enhance returns by
lending / pledging their stocks in return for an agreed fee on per share basis.

An investor holding stocks could lend stocks through SLBM (Security Lending and
Borrowing Mechanism) to traders who wish to …
… short-sell the stocks speculating stock price will fall…
…short-sell the stocks arbitraging the reverse cash futures spread i.e. futures trading at
discount to cash price.
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IAI SA7-1124

The risk of short-selling is borne by the borrowing trader and the investor would earn risk-
free incremental return on the idle stocks lent.

The only risk for lender is default by borrower where the lender receives close-out credit (an
estimated value of the shares) instead of shares leading to crystallization of capital gains tax. [2]

iv. Factors affecting recent high growth rate:

Recently the electric vehicle market in India saw a spike in sales. EVs are popular as cleaner
mode of transportation and public understands need to reduce pollution and greenhouse gas
emissions.

With rising petrol and diesel prices, EVs look attractive to customers in the long run.

EVs' lower operational and maintenance costs make them financially attractive alternative for
long-term savings.

The main problem with EVs is high initial purchase cost due to high cost of battery.

Government incentives on EVs made them affordable through subsidies. These incentives drive
consumers to choose EVs.

Government has also offered policy support to automakers like substantial tax breaks and
simplified registration processes for EVs.

Indian automakers are utilizing this opportunity by producing a wider variety of electric models.

This diversity allows consumers to choose an EV that fits their needs and budget.

To promote sale of EVs, government announced Electric Mobility Promotion Scheme (EMPS)
in 2024.

EMPS offers subsidy on EVs for example subsidy of up to INR 10,000 per two-wheeler,

Challenges for future growth rate:

In spite the subsidies; EVs are still more costly than petrol / diesel vehicles mainly due to cost
of battery.

Batteries become dead and need to be replaced in few years. This increases the cost.

Range anxiety is the fear of running out of battery without access to a charging station…
…due to the scarcity of charging infrastructure, especially in rural and suburban areas.

Re-fuelling petrol / diesel vehicles takes few minutes but to re-charge battery might take hours.

Apparently it seems using EVs will substantially reduce pollution, but reality is: majority of
electricity production is still dependent on burning coal.

During summers, few battery explosions happened while EVs were parked under sun.

Possible solutions to tackle the challenges:

• Advancements in battery technology:

Page 9 of 13
IAI SA7-1124

• develop batteries at lower cost by exploring other abundant raw materials / chemicals
• develop safer and more efficient batteries that charge faster and last longer to reduce range
anxiety

• Expanding charging infrastructure:

• The government and private sectors should work together to build a wider network of
charging stations across the country
• This includes installing stations in various locations, from urban centres to remote areas, to
ensure that EVs are a viable option for masses

Start-up of ancillary companies providing battery services:

• By owning and renting batteries to customers will reduce EV purchase cost
• Reduce waiting time at charging stations by swapping of charged batteries with low/no
charge rented batteries on payment of fee for the charging
• Customers going on vacation could deposit rented batteries at any charging station to reduce
rent cost
• Servicing batteries on a scheduled basis to check health of the batteries

• Continued incentives and support by government:

• Enhancing governmental incentives such as EMPS will help in maintaining the momentum
• Do awareness programs / ad campaigns of using EVs as cleaner mode of transportation
• Promote green energy initiatives like hydro projects, solar cells, wind mills etc. to replace
completely the dependency of electricity generation on coal
• Promote R&D (Research and Development) activities to develop new battery technologies
that are safer and more efficient by providing
o direct grants for R&D to research scholars
o substantial tax breaks / deductions for longer periods of time to encourage
companies engaged in R&D

Overall, a collaborative approach from government and private sector as stated above is
essential to tackle the challenges and achieve desirable growth of the EV industry. [12]

v. There has been an explosion of interest in factor exposures and the launch of a large number
of products based on many different types of factor. The expressions ‘factor-based investing’
and ‘smart beta’ are often used to capture this broad field.

Smart beta investing emphasizes the use of alternative index construction rules like equal
weighted or any other factor weighted instead of traditional market cap-weighted indices e.g.
Sensex or BSE500 or Nifty 50.

Categorisation according to size of a company and ‘value’ represented by the security remain
the most significant factor exposures today…
…other key factors include alpha, volatility, liquidity, quality, momentum etc.

Smart beta strategy is based on single or combination of multiple factors and is implemented
like typical passive index strategy.

It combines the benefits of active and passive investing strategies. The key difference
between active and smart beta investing is that for active fund managers there is full discretion
to hold or replace a stock…
…whereas for smart beta fund managers every inclusion or removal of a stock is set on rules
based system…
…though rules for a smart beta fund may be slightly different as set by the fund manager than
the rules of alternative index benchmark.
Page 10 of 13
IAI SA7-1124

Smart beta focuses on capturing investment factors or market inefficiencies in a rules-based

transparent manner.

Popularity of smart beta increased due to a desire for portfolio risk management and
diversification along factor dimensions...
…aiming enhanced risk adjusted returns above market cap-weighted indices. [4]

vi. Rules to create / maintain index benchmark for a smart beta fund:

Number of stocks in a smart beta benchmark index is set to be N (e.g. 30 or 50).

Stock selection is designed to provide exposure to high ranking factor (alpha) companies
constituting BSE500 at the time of inception / rebalancing.

The method employs a factor driven selection criteria that aims to maximize factor (alpha)
value while providing stability and tradability…
…by applying some filters to make the benchmark index investible and replicable.

Weights for each selected stock could be equal weighted or free float market-cap based or
some function of the factor value / ranking.

The method should specify

• the base date
• frequency of rebalancing say quarterly or annually etc.
• the time period (quarter or half-year or year) of past data to be considered in assessing
the factor (alpha) values

Identify eligible stocks from BSE500 index and apply some sanity filters like:
• To allow stability apply filters like
o minimum market cap
o maximum leverage
o minimum ROE (Return on Equity)
o positive EPS (Earnings Per Share) in past ‘n’ years etc.
• To allow liquidity / tradability apply filters like
o minimum average daily turnover / traded volume
o minimum trading frequency say 90% in last one year
o maximum average impact cost
o maximum average bid-offer spread etc.

Alpha of eligible stocks are calculated using one year trailing prices adjusted for corporate
actions, if any.

Stocks are ranked in descending order of alphas and top N=30 will form the index at inception
and at rebalancing buffer is applied to reduce frequent replacements.

To reduce frequent replacement of index constituents, a buffer of say 50% or 100% is applied
at each rebalancing. For N=30, buffer of 50% (100%) means existing constituent will be
retained provided it ranks in top 45 (60) by alpha values.

If weights are factor based then stocks with high values of factor (alpha) will get higher weight
and weight is proportional to its value i.e. weight of ith stock = (alpha of ith stock) / (sum of
alphas of all N constituent stocks)
[6]

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IAI SA7-1124

Any cap say 10% or 20% on weight of individual stock is applied to allow diversification
where weights may go beyond cap between rebalancing periods.

vii. Possible merit is “diversification” benefit ...

... Crypto returns are loosely correlated with returns on other assets ...
... Crypto currencies may be able to marginally improve portfolio returns without increasing
portfolio risk.

Crypto currencies’ prices are highly volatile that could be seen favourably by speculative
investors / traders ...
...But they have limited use and appeal for institutional investors.

The fluctuations in value of crypto currencies would disturb most investors who see their
savings / wealth change materially overnight.

They can be used as a medium of exchange although their ‘non government’ nature has
arguably made them more attractive for transactions that may not be 100% legal.

It is necessary to convert standard currency into a crypto ‘wallet’ and then to convert it back
at some point ...
... This exposes investor to the risk that the company conducting this business goes bust or is
exposed to fraud or cyber-attack ...
... For example, crypto platform WazirX reports assets worth $ 230 million were stolen /
hacked.

In most exchanges / platforms, Crypto currencies are priced in foreign currency like $ USD
and not in INR leading to currency risk in redemption of crypto wallet.

Many central banks have actively strived to discourage individuals and companies from using
crypto, saying that the risks of fraud and volatility are too great and represent a systemic risk.

Other key demerits arise from adverse taxation of Crypto currencies in India:

In Indian Budget 2022-23, taxation of Virtual Digital Assets (VDAs) like Bitcoin was
introduced ...
... Income from transfer of any VDA is taxed at 30% (plus cess) irrespective of whether the
income is treated as capital gains or business income.

Except cost of acquisition of VDA, no deduction / expenditure or allowance is allowed while

computing taxable income ...
... For example, infrastructure cost incurred on mining crypto assets will not be treated as cost
of acquisition.

Loss from transfer of VDA cannot be set off against any other income ...
... Losses incurred from one digital currency cannot be set-off against income from another
digital currency ...
... And losses from VDAs cannot be carried forward to offset gains in future years.

A buyer who owes a payment to the seller must subtract the TDS of 1% and forward it to the
central government ...
... Only the balance amount will be paid to the seller.

For transactions on Indian exchanges: the exchange will automatically deduct the TDS and
pay the balance to the seller. [7]

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IAI SA7-1124

viii.
The definition of VDAs covers crypto assets like Bitcoin, Non-Fungible Tokens (NFTs) and
‘notified assets’ and does not include crypto derivatives.

Moreover, ‘notified assets’ have not been specified by the government yet. Since crypto
derivatives are not crypto assets, they would be taxed as normal derivative products, and VDA
taxation may not apply to them.

Therefore, gains in crypto derivatives would be taxed as per normal tax slab, and losses could
be carried forward to offset gains in future years.

However, if investors choose to take delivery of the contract i.e. physical settlement, then the
gains would be taxed as VDAs.

Income tax is a highly technical and evolving law. As per current taxation laws there seems
no tax evasion by these exchanges that offer a crypto-INR paired derivatives.

But taxation risks exist and the government can look to add crypto derivatives under `notified
assets’, which brings them under VDA taxation that is very stringent.

Though the classification change may not be implemented retrospectively, there are other
risks associated with dealing in crypto derivatives.

Crypto derivative contracts may trade with small trading volumes, low liquidity and wider
bid-ask spreads. It would be difficult to execute trades at desired prices.

In addition, there is investment risk in derivatives where leverage can amplify returns and can
also magnify losses; most of the time leading to loss of entire capital. [3]

ix. 95% one week VaR using percentiles = 10,00,000 (1 - e^(-3.5%)) = 34,395

Assuming Log Normal (LN) distribution of returns

95% one week VaR = 10,00,000 (1 - e^(0.31% - 1.6449 (2.43%))) = 36,200

Assuming LN distribution of returns and 52 weeks in a year

95% 1 yr VaR = 10,00,000 (1 - e^(52 (0.31%) - 1.6449 (52^0.5) (2.43%))) = 1,19,298 [5]
[50 Marks]

***********************

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 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

24th May 2024

Subject SA7 – Investment and Finance

Time allowed: 3 Hours 15 Minutes (14.45 - 18.00 Hours)
Total Marks: 100
IAI SA7-0524

Q. 1) You are the Chief Investment Officer (CIO) of a medium-sized pension fund that has
recently committed to fully integrating sustainable investment principles into its investment
strategy while maintaining its obligations to its beneficiaries.
The board of trustees has tasked you with developing a strategic investment plan that aligns
with the fund's sustainability goals, addresses the long-term liabilities, and navigates the
current global economic uncertainties.
The first part of the plan is to develop Investment Policy Statement (IPS).

i) Explain the key components of the IPS that incorporate sustainable investment
principles and how they will guide the pension fund's investment decisions. (5)

ii) Explain how the IPS addresses the fund's long-term liabilities, risk tolerance, and
expected rate of return. (5)

The next stage involves formulating the Strategic Asset Allocation (SAA) to align with the
IPS.

iii) Discuss the three approaches of ESG investment decision making: integration,
thematic, and screening. (5)

iv) Considering the fund's commitment to sustainability, outline a strategic asset allocation
strategy that balances traditional asset classes with green bonds, renewable energy
investments, and other ESG-focused assets. (7)

After a lot of deliberation the board has approved the below SAA recommendation made
by you:

A B C Total
Private Equity 0% 0% 10% 10%
Private Debt 0% 15% 0% 15%
Public Equity 2% 5% 10% 17%
Public Debt- Investment Grade 15% 20% 15% 50%
Public Debt- Sub investment
Grade 3% 5% 0% 8%
20% 45% 35%

Where:
A Normal Industries excluding Coal, tobacco, gambling and similar classes.
Transitional industries actively working to move away from
B environmentally harmful products
C Industries actively contributing to sustainable goals

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IAI SA7-0524

v) Analyse the expected impact of the chosen SAA on the fund's long-term performance,
risk profile, and ability to meet its liabilities. Provide a rationale for including each
asset class. (9)

ESG ratings have been chosen as a method to strike a balance between ESG impact and
investment returns. The IPS requires finding the right equilibrium between sustainability
goals and investment returns.

vi) Discuss how this balance can be achieved through the use of ESG ratings. (4)

vii) Discuss potential issues related to using ESG ratings and governance for long-term
performance monitoring. (5)
[40]

Q. 2) As a senior fund manager at a large traditional fund house, you have observed a decline in
public trust due to increasing costs and reported cases of cybercrimes in the financial
market. Recently, you attended the "FinTech and Blockchain Summit 2024" in New Delhi,
where experts discussed the future of finance and investment.
One important topic at the summit was how new technologies could revolutionize the
management of investment portfolios in India, leading to enhanced consumer confidence
and reduced fund management costs.
Sessions such as "Tech-Driven Finance" and "Secure Investing with Blockchain" explored
the potential changes these technologies could bring to portfolio management.

i) Discuss specific technologies or platforms that could be integrated into the fund's
operations to improve efficiency, transparency, and security. (7)

ii) Considering the rapid growth of digital assets like cryptocurrency and NFTs (Non-
Fungible Tokens), analyse the feasibility and implications of including these emerging
asset classes in the pension fund's portfolio. Assess the associated risks, returns, and
regulatory considerations. (6)

Recent analysis has revealed that the Price-to-Earnings (PE) ratios of Indian companies are
significantly higher than their global counterparts, leading to differing opinions on the
future return prospects of the Indian stock market. Interestingly, despite these high
valuations, there has been a substantial influx of foreign capital into the market in the past
six months.

iii) Analyse the potential causes and highlight any imminent risks associated with
investing in the Indian Equity Market. (7)
[20]

Q. 3) As the Chief Investment Officer (CIO) of a global life insurance company with major
presence in developed country, your role involves overseeing the investment strategy for a
range of insurance products, including with-profits, non-profit, and unit-linked policies.
Each of these products comes with its own set of guarantees that are subject to market
fluctuations. Your main responsibilities include ensuring that the duration of assets matches
the liabilities, complying with capital requirements, and managing indexed liabilities with

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IAI SA7-0524

appropriate assets. It is important to incorporate the use of derivatives for cash flow
matching and to remain adaptable to regulatory changes.
Note: the use of derivative should be considered from global perspective without any
local regulatory constraints applicable in India.

i) Discuss the nature and type of liabilities (including Guarantees) and associated risk
which Insurance company is exposed to for above lines of product. (8)

Currently, the calculation of regulatory capital for the insurance company is based on a
factor-based approach. However, the regulator is interested in transitioning to a principle-
based approach. In this new approach, one of the recommended methods for assessing the
Asset Liability Management (ALM) risk and capital requirement is the utilization of
stochastic modelling.

ii) Explain how stochastic modelling can aid in understanding the impact of market
conditions and the overall capital adequacy of the insurance firm under risk-based
capital (e.g. Principle based reserving (PBR) or Solvency II(SII)) approach specifically
discussing confidence level, correlation of risk and time horizon of the risk. (5)

Currently the company is projecting multiple scenarios of future Profit and loss account and
Balance Sheet, where reserve for guarantees are estimated using closed form
approximations.

iii) Explain how stochastic modelling can be used to estimate the value guarantees.
Discuss the consideration of using this approach compared with close form solution. (5)

iv) Explain how P&L and Balance Sheet projections under various scenarios can be used
to assess the resilience of a portfolio? (5)

Company has decided to use Liability Driven Investment (LDI) approach to reduce the
market risk exposure.

v) Without performing actual calculations, outline LDI strategies for each of below
derivatives to manage market risk.

1) Bonds + Swaps
2) Swaptions
3) Total return swap (10)

vi) Despite their benefits, LDI strategies introduce specific new risks. Detail these
additional risks that emerge as a result of implementing LDI. (3)

The company has the following asset and liability exposure:

Asset Exposure
Equities 1000
Properties & infra 600

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Credit 200
Index linked bonds 1600
Cash 800
4200

Liabilities 4000
Duration 25
Percent of liability which is inflation
70%
linked
Average duration of index linked bond 17

Assume that assets than index linked bonds do not contribute to inflation and interest
protection.

vii) Determine the current hedge ratio. (4)

[40]
******************************

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INSTITUTE OF ACTUARIES OF INDIA

SA7 - Investment and Finance

May 2024 Examination

INDICATIVE SOLUTION

Introduction

The indicative solution has been written by the Examiners with the aim of helping candidates.
The solutions given are only indicative. It is realized that there could be other points as valid
answers and examiner have given credit for any alternative approach or interpretation which
they consider to be reasonable.
IAI SA7-0524

Solution 1:

i)
1. Sustainability Objective Statement: The IPS should start with a clear declaration of the fund's
commitment to sustainability, defining specific environmental, social, and governance (ESG)
criteria.
2. Risk Management Framework: Incorporate ESG risk factors into the overall risk
management strategy, highlighting how sustainability risks are identified, assessed, and
managed.
3. Asset Allocation Guidelines: Specify guidelines for including ESG-focused investments and
outline restrictions on non-sustainable industries like coal, tobacco, and gambling.
4. Investment Selection Process: Describe the process for selecting investments based on ESG
criteria, utilizing integration, thematic investment, and screening approaches.
5. Monitoring and Reporting: Detail procedures for monitoring ESG performance of
investments and reporting to stakeholders on sustainability impacts and financial returns.
6. Review and Adjustment Protocol: Establish protocols for regularly reviewing and adjusting
the IPS in response to evolving sustainability goals, market conditions, or regulatory changes.
7. Stakeholder Engagement Plan: Outline approaches for engaging with stakeholders on ESG
investment decisions and performance.
8. Governance Structure: Define the governance structure overseeing ESG integration into
investment decisions, including roles and responsibilities.
9. Compliance with Regulations: Ensure the IPS aligns with current and anticipated regulations
related to sustainable investments.
10. Training and Education: Commit to ongoing training for the investment team on ESG issues,
trends, and analysis techniques.
(0.5 marks for each point, Max 5)

ii)

1. Liability-Driven Investing Focus: Emphasize how the IPS prioritizes matching the duration
and cash flows of assets to liabilities, especially through the use of ESG-aligned investments.
2. Risk Tolerance Alignment: Discuss the alignment of the fund's risk tolerance with sustainable
investment strategies, considering both financial and ESG risks.
3. Expected Rate of Return: Specify how the IPS integrates expected financial returns with ESG
impact, balancing the dual objectives of sustainability and financial viability.
4. Diversification Strategy: Highlight how diversification is used to manage risk, including
diversification within ESG investments.
5. Asset-Liability Matching: Explain strategies for asset-liability matching, particularly through
investments in green bonds and other ESG-focused assets that align with the fund's liability
profile.
6. Inclusion of ESG Investments: Rationalize the inclusion of specific ESG investments for their
potential to contribute to the fund’s long-term sustainability and financial objectives.
7. Portfolio Rebalancing Criteria: Define criteria and thresholds for rebalancing the portfolio to
maintain alignment with long-term liabilities, risk tolerance, and sustainability goals.
8. Performance Evaluation Metrics: Establish metrics for evaluating the performance of the
portfolio, including both financial returns and ESG impact.
9. Regulatory Compliance Assurance: Ensure strategies are in place for the fund to remain
compliant with evolving regulations related to sustainability and investment practices.
10. Flexibility for Future Adjustments: Emphasize the importance of flexibility in the investment
strategy to adapt to changing market conditions, ESG factors, and regulatory requirements.
(0.5 marks for each point, Max 5)

iii)

1. Integration Approach

The integration approach merges ESG factors with traditional financial analysis. Investors assess
how ESG issues can affect a company's financial performance and risk, aiming to choose companies
that manage these aspects well for better long-term returns. It's a holistic view that considers ESG
elements as integral to evaluating a company's overall health and prospects. (2 Marks)

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IAI SA7-0524

2. Thematic Investment Approach

Thematic investing focuses on specific ESG themes, such as clean energy or social equality, to
guide investment choices. This approach invests in sectors or companies expected to grow from
these global ESG trends. It aligns investments with broader social or environmental goals,
potentially generating positive impacts alongside financial returns. (1.5 Marks)

3. Screening Approach
Screening applies filters to include or exclude companies based on ESG criteria. Negative screening
avoids companies engaged in undesirable activities (like tobacco or fossil fuels), while positive
screening selects companies with strong ESG practices. This method can also include best-in-class
screening, where investors choose the top ESG performers within each sector.
Each approach provides a different pathway for investors to incorporate ESG considerations into their
portfolios, whether through a broad integration of ESG factors, focusing on specific sustainability
themes, or applying ESG-based filters to investment selections.
(1.5 Marks)
(5)

iv)

1. Diverse Asset Mix: Create a diversified portfolio that includes a mix of traditional asset classes
(equities, fixed income) and ESG-focused investments. The aim is to achieve a balance that not
only provides financial returns but also contributes positively to environmental and social
outcomes.
2. Green Bonds Allocation: Allocate a significant portion of the fixed-income segment to green
bonds. These bonds finance projects with environmental benefits, such as renewable energy,
pollution prevention, and climate adaptation, aligning with the fund's sustainability goals.
3. Renewable Energy Investments: Dedicate a part of the equity allocation to companies in the
renewable energy sector, including wind, solar, and hydroelectric power. This supports the
transition to a low-carbon economy and taps into the growth potential of clean energy.
4. ESG-Focused Assets: Incorporate other ESG-focused assets, such as investments in companies
with strong records in social responsibility and governance. This includes firms with practices
that promote gender diversity, employee well-being, and ethical governance.
5. Risk Management: Ensure that the inclusion of ESG-focused investments does not
compromise the fund's risk profile. Use ESG ratings and analyses to assess the risk and return
profile of these investments, aiming for an optimal risk-adjusted return that meets the fund's
long-term liabilities.
6. Regular Review and Rebalancing: Establish a mechanism for the regular review and
rebalancing of the asset allocation to adapt to changing market conditions, advancements in
sustainable investing, and shifts in ESG criteria and ratings. This ensures the fund remains
aligned with its sustainability commitment and financial objectives.
7. Stakeholder Engagement: Engage with stakeholders, including beneficiaries, about the
strategic asset allocation strategy. Communicate how the fund's commitment to sustainability
is reflected in its investment choices and how these choices impact financial returns and
contribute to broader environmental and social goals.

This strategic asset allocation strategy demonstrates the fund's commitment to sustainability by
thoughtfully integrating green bonds, renewable energy investments, and other ESG-focused assets with
traditional investments, ensuring a balanced approach that seeks to optimize both financial returns and
positive ESG outcomes.
(1 mark for each point, Max 7)

v) Expected Impact of the Chosen SAA [8 Marks]

1. Private Equity (10%) - Actively Contributing to Sustainable Goals: Allocating 10% to

private equity focused on sustainable goals reflects a strategic move to invest in companies
driving positive environmental and social change. This can potentially offer higher returns due
to the growth prospects of sustainable industries. However, it introduces liquidity and valuation
risks, balanced by the long-term growth potential of green technologies and sustainable
business models.
(1 Mark)

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IAI SA7-0524

2. Private Debt (15%) - Transitional Industries: Investing 15% in private debt within
transitional industries signifies the fund's commitment to supporting sectors moving towards
more sustainable practices. This approach aims to yield stable returns from investments in
industries adapting to environmental norms, albeit with moderate credit risk and potential for
transformational impact.
(1 Mark)

3. Public Equity (17%) - Diverse Allocation: Diversifying public equity across normal assets
(2%), transitional industries (5%), and those actively contributing to sustainability (10%)
enhances the portfolio's growth potential while aligning with ESG principles. The varied
allocation allows the fund to benefit from broader market growth while specifically targeting
sectors with high sustainability impact, though it exposes the portfolio to market volatility.
(2 Marks)

4. Public Debt - Investment Grade (50%): The significant allocation to investment-grade public
debt (50%) serves as the foundation for stability and risk mitigation within the portfolio. It
ensures a steady income stream to meet liabilities while maintaining a low-risk profile. This
conservative approach prioritizes capital preservation and liquidity, essential for meeting the
fund's long-term obligations.
(2 Marks)

5. Public Debt - Sub-Investment Grade (8%): Including a smaller portion of sub-investment-

grade debt introduces a calculated risk for potentially higher yields. This segment targets higher
returns but comes with increased credit risk, justified by the diversification benefits and the
potential for outsize gains from underappreciated assets.
(1 Mark)
6. Impact on Long-Term Performance and Risk Profile: Overall, the SAA aims to balance risk
and return by mixing growth-oriented investments with stable, income-generating assets. The
focus on sustainability and transitional industries positions the fund to capitalize on future
trends, with a keen eye on ESG principles, potentially enhancing long-term performance.
(1 Mark)
7. Liability Matching Considerations: The emphasis on investment-grade public debt aligns
with the fund's need for liability matching, ensuring sufficient liquidity and predictable returns.
This allocation strategy supports the fund's obligations to its beneficiaries by prioritizing assets
that offer security and stability, crucial for a pension fund's long-term liability management.
(1 Mark)
(9)
vi)

1. Objective Assessment: ESG ratings reveal financial stability and sustainability practices
together, aiding in selecting companies that are both environmentally responsible and
financially sound, thus promising lower risk and potential for higher returns.
2. Risk Mitigation: High ESG scores typically indicate lower risk, as well-managed companies
face fewer fines and disruptions. This contributes to more stable and predictable returns for the
fund.
3. Sectoral Analysis: ESG ratings help identify sector leaders in sustainability who often achieve
better financial performance due to their competitive edge, aligning investment with both
profitability and sustainability goals.
4. Performance Correlation Historical trends show that companies with high ESG ratings often
outperform their peers financially, suggesting that integrating ESG considerations can enhance
long-term financial returns alongside positive environmental and social impact.
5. Strategic Diversification: Using ESG ratings enables diversified investments across various
sectors, balancing exposure to risks and opportunities for both sustainability and competitive
market returns.
(1 mark for each point, Max 4)

vii) While ESG ratings are valuable for integrating sustainability into investment strategies, several
issues can arise, particularly regarding long-term performance monitoring:

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IAI SA7-0524

1. Inconsistency Across Providers: Different ESG rating agencies may use varied criteria and
methodologies, leading to inconsistent ratings for the same entity. This inconsistency can
complicate the assessment of a company's true ESG performance over time.
2. Lack of Transparency: ESG rating processes and the specific data used can sometimes lack
transparency, making it challenging for investors to understand how ratings correlate with
actual sustainability impact and financial performance.
3. Data Quality Concerns: The quality and availability of ESG data can vary significantly across
companies and sectors, potentially leading to inaccurate ratings that do not fully reflect a
company's sustainability practices or risks.
4. Short-Term Focus: ESG ratings may not always capture long-term sustainability risks or
opportunities, as they can be overly influenced by short-term events or achievements, leading
to a misalignment with the long-term investment horizon of a pension fund.
5. Governance and Bias Issues: The subjective nature of some ESG assessments can introduce
biases, and governance standards within rating agencies themselves may impact the neutrality
of ratings. This can affect the reliability of ESG ratings for making long-term investment
decisions and monitoring performance.
(1 mark for each point, Max 5)
[40]
Solution 2:

i) Several emerging technologies could significantly improve the operations of investment funds
by enhancing efficiency, transparency, and security:
1. Blockchain Technology: Offers a decentralized and secure ledger system for recording
transactions, reducing the risk of fraud and enhancing transparency in asset management.
(1.5 Marks)
2. Robo-Advisors: AI-driven investment platforms can automate and optimize asset allocation,
providing data-driven insights to improve decision-making and efficiency.
(1.5 Marks)
3. Smart Contracts: Automated contracts executed over blockchain ensure faster, error-free
agreements between parties, streamlining operations like fund distribution and compliance.
(1.5 Marks)
4. Digital Identity Verification: Enhances the security and speed of customer onboarding and
compliance processes by leveraging advanced digital verification methods.
(1.5 Marks)
5. Distributed Ledger Technologies: Beyond blockchain, these technologies provide alternatives
for secure, real-time transaction and asset management, minimizing counterparty risks and
improving settlement times.
(1 Mark)
(7)

ii) Inclusion of Digital Assets in the Portfolio

The inclusion of digital assets like cryptocurrencies and NFTs (Non-Fungible Tokens) into a
pension fund's portfolio requires a balanced analysis of potential benefits against associated risks
and regulatory challenges:

1. Diversification: Digital assets can offer portfolio diversification benefits due to their unique
risk-return profiles and low correlation with traditional asset classes.
(1.5 Marks)
2. Volatility and Security Risks: The high price volatility of digital assets and potential security
issues, such as hacking and fraud, pose significant investment risks that need careful
management.
(1.5 Marks)
3. Regulatory Landscape: The evolving regulatory framework for digital assets affects their
feasibility as an investment. Regulatory uncertainty and compliance requirements must be
thoroughly evaluated to ensure alignment with legal standards and protect the fund's interests.
(1.5 Marks)
Incorporating digital assets into a pension fund's investment strategy could offer new opportunities for
growth and diversification but necessitates diligent risk assessment and regulatory compliance to
safeguard the fund's long-term objectives and responsibilities to its beneficiaries.
(1.5 Marks)
(6)
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IAI SA7-0524

iii) Analysis of High PE Ratios and Foreign Capital Inflow into the Indian Equity Market

1. Growth Expectations: The high PE ratios largely reflect investors' optimism about India's
economic growth and corporate earnings potential, driving valuations higher as the market
anticipates robust future performance.
2. Global Low-Interest Rates: With global interest rates at historic lows, investors are drawn to
the higher returns potential in emerging markets like India, increasing demand for Indian
equities.
3. Liquidity Surge: Global monetary policies have injected significant liquidity into financial
markets, part of which has flowed into the Indian equity market, pushing up stock prices and
PE ratios.
4. Sector-Specific Demand: Certain high-growth sectors such as technology have attracted
significant investment, contributing to the overall high market valuations.
(1 mark for each point, Max 4)

Impending Risks

1. Correction Risk: Elevated PE ratios heighten the risk of a market correction if future earnings
do not meet expectations, potentially leading to significant price adjustments.
2. Inflation and Interest Rate Risks: Rising global inflation and potential interest rate hikes
could dampen the attractiveness of equities, possibly reversing the inflow of foreign capital.
3. Regulatory and Political Risks: Any adverse regulatory or political developments could
impact foreign investor sentiment and lead to capital outflows, affecting market stability.
In summary, while the Indian equity market's high valuations signal confidence in future growth, they
also introduce risks of corrections, alongside concerns over changing global financial conditions and
domestic policy shifts. Investors should proceed with caution, considering these factors.
(1 mark for each point, Max 3)
(7)
[20]

Solution 3:

i) Nature and Types of Liabilities

1. With-Profits Policies Liabilities: These policies combine investment with insurance, offering
policyholders a share of the profits in addition to guaranteed benefits. Liabilities here include
guaranteed annuity rates and bonuses declared. The guarantees can put pressure on the
company's reserves during downturns, as the insurer must provide the promised returns
regardless of market performance.
(1.5 Marks)

2. Non-Profit Policies Liabilities: Non-profit policies provide a fixed benefit and involve lower
risk since they don't share in the insurer's profits. The primary liability is the sum assured, along
with any additional guaranteed benefits like death or maturity benefits, which are known and
can be planned for.
(1.5 Marks)
3. Unit-Linked Policies Liabilities: In unit-linked products, policyholder funds are invested in
various units of investment funds, with returns directly linked to market performance. The main
liabilities include the management of the unit fund and the minimum death benefit guaranteed,
exposing the company to market risk as the asset value fluctuates.
(1 Mark)

Associated Risks
1. Market Risk: This is particularly relevant for with-profits and unit-linked policies, where
liabilities are closely tied to market performance. Poor investment performance can strain the
company's ability to meet guaranteed returns or benefits, impacting profitability and solvency.
(1 Marks)
2. Interest Rate Risk: Changes in interest rates can affect the value of both assets and liabilities.
For policies with guaranteed interest rates, falling market rates can make it challenging to
generate the returns needed to meet these guarantees, potentially leading to a mismatch in asset-
liability durations.
Page 6 of 9
IAI SA7-0524

(1 Marks)
3. Longevity Risk: For policies with annuity guarantees, longer-than-expected lifespans of
policyholders increase the period over which payments must be made, potentially straining the
insurer’s financial reserves if not adequately anticipated.
(1 Mark)
4. Regulatory Risk: The insurance industry is heavily regulated, and changes in regulatory
requirements can impact the reserves needed for liabilities, the valuation of liabilities, or the
capital required to back these liabilities. This can necessitate adjustments in investment strategy
or product offerings to remain compliant.
(1 Mark)
(8)

ii) Stochastic modelling represents a sophisticated approach to understanding and managing the
myriad risks faced by an insurance company, especially under a principles-based reserving
(PBR) or Solvency II (SII) framework, where capital adequacy is critically evaluated. Here's
how stochastic modelling aids in this context:

Understanding the Impact of Market Conditions and Capital Adequacy

1. Comprehensive Risk Assessment: Stochastic modelling allows for the simulation of a wide
range of market conditions and their potential impact on the insurance firm's assets and
liabilities. By generating thousands of possible future scenarios, it provides a detailed risk
profile that includes both expected outcomes and tail risks.
(1 Mark)
2. Confidence Level Determination: One of the key benefits of stochastic modelling is its ability
to quantify the confidence level or the probability that the firm will meet its liabilities under
various conditions. For example, a 99.5% confidence level under the Solvency II framework
means the firm is expected to cover its liabilities 995 times out of 1000, given the modelled risk
scenarios.
(1 Mark)
3. Correlation of Risks: Stochastic models can capture the correlation between different types of
risks (e.g., market, credit, operational risks). This is crucial because risks are not independent;
their interplay can either amplify or mitigate the overall risk profile. Understanding these
correlations helps in devising more effective risk management and capital allocation strategies.
(1 Mark)
4. Time Horizon of Risks: Insurance liabilities often span several decades, making the time
horizon of risks a critical factor in capital adequacy assessments. Stochastic modelling allows
firms to assess how capital requirements might change over different time horizons, considering
the potential for long-term trends, such as inflation or changes in mortality rates, to impact
liabilities.
(1 Mark)
5. Principle-Based Approach (PBR/SII) Compatibility: Moving from a factor-based to a
principle-based approach for calculating regulatory capital, as seen in PBR or SII, requires a
deep understanding of the nature, magnitude, and management of risks. Stochastic modelling
provides the necessary analytical depth to evaluate ALM risks and capital requirements under
this advanced regulatory framework, aligning capital adequacy assessments with the actual risk
profile of the firm.
(1 Mark)
(5)

iii) Stochastic modelling offers a dynamic method for estimating the liabilities associated with
insurance guarantees in a base scenario by acknowledging the complexity and uncertainty
inherent in financial markets.
1. Risk-Neutral Valuation: By employing a risk-neutral scenario projection, stochastic
modelling calculates the present value of future pay-outs associated with guarantees without
assuming any risk preferences, leading to a mathematically robust valuation.
2. Reflecting Volatility: This approach captures the volatility of underlying assets over time,
offering a more accurate estimation of liabilities by considering the full range of possible
market movements that impact the guarantees year on year.

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3. Flexibility in Modelling: Unlike closed-form solutions, which may be constrained by their

simplifying assumptions, stochastic modelling allows for the incorporation of various complex
inputs and assumptions, providing a comprehensive view of potential liability variations.
4. Scenario-Specific Forecasts: Stochastic models can forecast a multitude of economic
scenarios, reflecting the potential variability in guarantees, which is particularly useful when
the guarantees are sensitive to multiple risk factors that may not be accurately captured by a
closed-form approach.
5. Adjustment for Model Risk: Given that closed-form solutions may not fully capture the
nuances of guarantee-related liabilities, stochastic modelling offers a more nuanced approach
that can be adjusted for model risk, leading to potentially more reliable estimations of liabilities.
(1 mark for each point, Max 5)

iv) Assessing Portfolio Resilience Using P&L and Balance Sheet Projections
Assessing the resilience of a portfolio through P&L and Balance Sheet projections under various
scenarios allows for an evaluation of how changes in market conditions might affect the financial health
of the insurance firm.
1. Visibility on Variability: Regular P&L projections help to visualize the variability of the
portfolio's performance over time, reflecting how changes in market conditions may affect
profitability.
2. Asset-Liability Matching: Balance Sheet projections can illustrate the efficacy of the firm's
asset-liability matching strategy, showing whether the assets are adequate to cover the liabilities
under various conditions.
3. Assumption Sensitivity: By altering assumptions in the projections, the sensitivity of the
portfolio to different risk factors can be analysed, offering insights into areas of potential
vulnerability.
4. Cash Flow Timing: Scenario projections help to estimate the timing and magnitude of cash
flows, both in and out, providing a clear picture of the fund's liquidity under various market
conditions.
5. Guarantee Assessment: Regularly projecting the P&L and Balance Sheet allows the firm to
assess the sufficiency of funds set aside for guarantees, ensuring that these obligations can be
met without impacting the overall stability of the portfolio.
(1 mark for each point, Max 5)

v) The Liability Driven Investment (LDI) strategy is designed to minimize market risk by aligning
investment returns with liability pay-outs. Below outlines how various derivatives can be used
in LDI strategies:

LDI Strategies Using Derivatives

1. Bonds + Swaps):
• Duration Matching: Use a combination of short-term bonds that provide higher
returns and interest rate swaps to manage duration mismatches. The swaps can be used
to convert the asset returns to match the fixed rate of return required by the liabilities.
• Cash Flow Matching: Align bond maturities with liability pay-outs to ensure that cash
flows from the assets coincide with the outflows required by policyholder obligations.
• Yield Enhancement: Select bonds that have higher yields but may not match the
duration of liabilities; use swaps to transform these yields into the desired duration,
thereby maintaining the portfolio's return requirements.
(1 mark for each point, 3 marks)

2. Swaptions:
• Interest Rate Lock-In: Purchase swaptions to secure the right, but not the obligation,
to enter into an interest rate swap at a future date. This can lock in interest rates for
liabilities that are sensitive to rate changes, such as future annuities vesting, ensuring
the company can set aside the right amount of funds today for future pay-outs.
• Flexibility in Strategy: Use swaptions to retain flexibility in adjusting the investment
strategy based on how interest rates move. If rates move unfavourably, the company
can exercise the swaptions to mitigate losses on guaranteed annuity products.
(1.5 mark for each point, 3 marks)

3. Total Return Swaps

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 IAI SA7-0524

• Fixed to Floating Returns: If asset returns are floating and liabilities are fixed, enter
into total return swaps where the company pays the floating rate and receives a fixed
rate. This can hedge the risk of interest rate movements affecting the returns required
to meet the fixed nature of policyholder benefits.
• Credit Risk Transfer: Use total return swaps to synthetically gain exposure to higher-
yielding assets without taking on additional credit risk. This strategy can enhance the
returns of the portfolio without compromising the quality of the assets.
• Liquidity Management: Since total return swaps do not require a significant initial
investment, they can be used to gain exposure to certain asset returns while maintaining
liquidity to meet short-term liabilities.
For longer-term non-profit liabilities, these LDI strategies can be tailored to ensure that the
company invests in assets that offer higher returns without exposing the firm to undue duration
or interest rate risk. The use of swaps, swaptions, and total return swaps allows the company to
fine-tune its asset allocation and risk exposure to match the specific characteristics of its
liabilities, securing its financial position against market volatility.
(1 mark for each point, 4 marks)
[10]

vi) New Risks Introduced by LDI Strategies:

Counterparty Risk: When using derivatives like swaps or swaptions in an LDI strategy, there is the
risk that the counterparty to the derivative contract may default, particularly during times of financial
stress. This could result in losses or additional costs to replace the contracts.

Liquidity Risk: LDI strategies often involve locking in assets to match liabilities, which can reduce
the portfolio's liquidity. The company might find it challenging to meet unexpected cash flow needs
without incurring significant costs.

Mismatch Risk: There is a risk that the derivatives used in LDI strategies may not perfectly match the
liabilities they are intended to hedge. Small discrepancies can accumulate over time, especially with
complex products or in changing market conditions, potentially leading to an imperfect hedge and
exposure to market risk.

These risks underscore the importance of careful risk management and due diligence when
implementing LDI strategies. While they are designed to mitigate market risk, the complexity and
dependencies they introduce need to be closely monitored and managed.
(1 mark for each point, Max 3)

vii)

PV 01 of index linked -2.72 =duration x exposure/-10000

Liabilitiy PV 01 -10
IE01 of liabilities -7
IE01 of assets -2.72
=PV01 asset/PV01 of
Hedge ratio of interest rate 27% liabilities
Inflation hedge ratio 39%

(4)
[40]

**********************

Page 9 of 9
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

23rd November 2023

Subject SA7 – Investment and Finance
Time allowed: 3 Hours 15 Minutes (14.45 - 18.00 Hours)
Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions inside the cover page of answer booklet and instructions
to examinees sent along with hall ticket carefully and follow without exception.
2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.
3. Attempt all questions beginning your answer to each question on a separate sheet.
4. Mark allocations are shown in brackets.
5. Please check if you have received complete Question Paper and no page is missing.
If so, kindly get new set of Question Paper from the Invigilator.

AT THE END OF THE EXAMINATION

Please return your answer book and this question paper to the supervisor separately. You are not
allowed to carry the question paper in any form with you.
IAI SA7-1123

Q. 1) You are an investment consultant having banks, mutual funds and hedge funds as clients.
One of your bank client, XYZ Bank Ltd., seeks your help in introducing a new product;
monthly RD (Recurring Deposits) to its customers. In Bank RD, normally the interest is
calculated on a quarterly compounding basis where customer deposits a fixed amount every
month and receives a lump sum amount on maturity. Generally, Banks quote RD rates as
X% p.a. compounding quarterly.

From the RD, XYZ intends to provide bank finance to small/medium scale companies that
are currently struggling to rely on borrowing from capital markets.

Banking Regulator uses varying interest rates as a tool to control inflation and economic
growth that in return changes yields in bond markets.

For illustration purpose, assuming all deposits are done in time and all months have same
duration, your team member has suggested a formula for maturity value of RD as:

[(1 + 𝑖)𝑛 − 1]
𝑀=𝑅 −1
[1 − (1 + 𝑖)( 3 ) ]

Exact maturity value of RD paid to customer is calculated in RD administration system

based on actual dates of deposits and actual number of days in any month/quarter/year.

One of your hedge fund client, DEF Hedge Fund, seeks your help in assessing a strategy
using stock (equities) options trading in an order driven market structure. The options
strategy is similar to the following example:

ABC Ltd. company has declared dividend of 20 per share; ex-dividend date is 30 days from
today. ABC share is currently trading at 790.

Strategy

Short a European put at strike price 800 (option premium = 40).

Long a European put at strike price 725 (option premium = 20).
Short a European call at strike price 800 (option premium = 50).
Long a European call at strike price 850 (option premium = 30).

• Put option short position expiry is 15 days from today.

• Put option long & Call options long/short positions expiry is 45 days from today.
• Contract (Market lot) size is 1100 units.
• All ITM (In-The-Money) options are settled at expiry by physical delivery of shares.
• Investment horizon is 45 days and any positions held will be closed by 45 days from
today.

i) Mention the advantages and disadvantages of bank finance compared to borrowing

in the capital markets. (3)

ii) Discuss the impact of change in interest rates on Bank’s profitability and risks. (5)

iii) Discuss the issues to be considered in product design and pricing / re-pricing of RD. (10)

iv) Explain the formula for maturity value of RD suggested by your team member. (3)

Page 2 of 4
IAI SA7-1123

v) Derive a formula for maturity value of RD. (4)

vi) Explain whether the formula suggested by your team member or the formula derived
by you will give higher maturity value for RD. (3)

vii) Write a note on order driven market structure. Your answer should include types of
orders and their validity. (7)

viii) Prepare a report on the DEF’s options strategy. Consider all possible future scenarios
in the report and include statements / comments on the following.

• The level (or range) of ABC share price where the strategy is profitable or loss
making or breaks-even; consider all break-even points,
• The strategy’s maximum profit and maximum loss.
• Initial capital / margin requirement.
• Views, of a person implementing the strategy, on ABC share price movements
in coming 45 days. (10)

ix) Plot a rough diagram for the options strategy that shows the total payoff at
investment horizon (45 days from today) against the settlement price of ABC share
(over a range 600 – 1000). The diagram should represent a future scenario where
share price < 800 at end of 15 days. (5)
[50]

Q. 2) As the recently appointed investment Actuary for a significant private trust that supports the
educational expenses of financially disadvantaged high school students, you are tasked with
evaluating the trust's existing investment approach and recommending potential
enhancements. The trust presently sponsors the tuition fees of 2,500 students and aims to
sustain this assistance indefinitely.

Your directive from the trustees is to assess the current investment strategy of the trust and
propose viable avenues for improvement.

i)
a) State the information you would need for your analysis. (3)

b) Discuss the considerations that would influence your choice of strategic asset
allocation benchmark. (3)

c) Propose a benchmark stating any assumptions you make. (6)

d) What factors would you consider while determining the appropriate weight between
equities and bonds in a benchmark for a long-term investment strategy that aims to
support educational expenses for financially disadvantaged high school students? (5)

Thorough your analysis, it has come to light that a notable portion of the trust's assets,
specifically 15%, is allocated to the unlisted shares of Stellar Electronics Inc., a regional
technology firm previously owned by a former trustee. Comprehensive financial
information for Stellar Electronics Inc. is at your disposal, as demonstrated as follows.

Page 3 of 4
IAI SA7-1123

2019 2020 2021 2022

Sales (INR lakhs) 498 503 511 520
Net profit margin 2.4% 2.1% 1.9% 1.7%
Dividend payout ratio 85% 105% 115% 120%
Debt/equity ratio 42% 48% 52% 57%

ii)
a) Discuss the financial condition of Stellar Electronics Inc. (3.5)

b) State what further information you would require to make a more complete
analysis of the investment in Stellar Electronics Inc. (3.5)

iii) Describe how the potential risks to the trust posed by the Stellar Electronics Inc.
holding might be managed? (6)

The managers of a buyout-oriented Private Equity (PE) fund have approached the
shareholders of Stellar Electronics Inc. with a view to purchasing the company. They are
proposing a swap of shares for an interest in the private equity fund for a 10% equity stake
in the PE fund.

iv) Discuss the key information that you require in order to assess the merits of this
proposal from the perspective of the trust. (10)

The listed equity portion of the trust’s assets are managed to a Nifty50 Index benchmark by
Actuaria Asset Management (AAM). During your investigation, you have received from the
trustees the following statistics relating to the equity portfolio which AAM manages for the
trust.

5-year performance: 18% annually (benchmark return: 12% annually).

1-year performance: -3% (benchmark return: +2%).
IT sector exposure: 3% of listed equity portfolio.
Historic annualized tracking error: 8%
Average stock P/E ratio: 12
Portfolio turnover: 25% annually.

v)
a) Describe the management style of AAM and the other characteristics that you
would expect to observe in the portfolio of a manager such as AAM. (5)

b) Explain how you would communicate the investment performance to the trustees
in a clear and meaningful manner, considering their diverse backgrounds and
expertise levels. Provide examples of visual aids or reports you might use. (5)
[50]

**************************

Page 4 of 4
 Institute of Actuaries of India

Subject SA7-Investment and Finance

November 2023 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates. The
solutions given are only indicative. It is realized that there could be other points as valid answers and
examiner have given credit for any alternative approach or interpretation which they consider to be
reasonable.

Page 1 of 15
 IAI SA7-1123

Solution 1:
i) Bank finance offers numerous benefits relative to raising finance in the capital markets.
The advantages include:
• the development of a relationship between the company and the bank which can
bring about stability of finance costs, known depth of access and flexibility to
change terms
• costs of finance can be lowered by companies that use the bank for other services (e.g.
paying fees for managing bond issuances)
• advice on finance due to a regular contact with the bank
• no need for credit rating agency involvement in management time

The disadvantages, include:

• the restrictions imposed by banks can be far more penal than those demanded by capital
market investors
• generally, the term and size of debt available for bank finance is significantly shorter and
smaller than capital markets
• the relationship between capital market investors is generally more ‘arm’s length’ than
banks, freeing up management time
[Max 3]

ii) The banking sector's profitability increases (decreases) with interest rate hikes (cuts). Institutions
in the banking sector, such as retail banks, commercial banks, investment banks have massive
cash holdings due to CRR (Cash Reserve Ratio requirement) of customer balances and business
activities. Changes in the interest rate directly affect the yield on this cash, and directly alter
earnings.

Higher interest rates tend to reflect a period of greater economic growth, with the Banking
regulator raising rates to slow expansion. In these conditions, consumer and business demands
for loans spike, which also augments earnings for banks.

The spread between long-term and short-term rates also expands during interest rate hikes
because long-term rates tend to rise faster than short-term rates. Profitability increases as
longer-term loans earn more interest than shorter-term interest cost on deposits.

If interest rates rise too high, it can start to hurt bank profits as demand from borrowers for new
loans suffers and / or refinancing drops and increases deposit competition. Depositors may seek
other banks providing higher returns putting pressure on funding cost. To attract and retain
customer deposits, banks must be able to offer competitive deposit rates.

To manage the impact of rising interest rates on loan demand and cost of funding, banks must be
able to adjust their strategies on lending and deposit policies. Banks that rely heavily on lending
for revenue can diversify into areas, such as wealth management or investment banking. Banks
should maintain enough liquidity to deal with any changes in deposit levels.

Banks can differentiate themselves from competitors by offering innovative products and
services like high-yield savings accounts, mobile banking apps, and other digital services and
retain their customer base.

Banks also have large amounts of bonds in their portfolios. Bond prices typically fall (rise) when
interest rates rise (fall). To avoid significant losses / uncertainty, banks must manage their bond
portfolios effectively.

Page 2 of 15
IAI SA7-1123

Interest rate risk is the risk to a bank’s earnings and capital that occurs when interest rates
change. It arises primarily because the rates and prices of assets and liabilities change by
different amounts or at different times. It is comprised of four types of risk:
• Re-pricing risk occurs when assets (loans and investments) mature or re-price at different
times than liabilities (deposits and other borrowings).
• Basis risk arises when interest rate changes lead to a difference in how a bank’s assets
are re-priced versus its liabilities.
• Yield curve risk arises from non-parallel changes in the yield curve. The rate change on a
two-year government bond, for example, may differ from that on a 10-year government
bond.
• Option risk arises when the timing or amount of a bank’s cash flows changes because of
a decision by a customer on interest rate change; bank borrower (e.g., a loan customer)
or lender (e.g., deposit customer).

For many banks, re-pricing risk is of the most concern. They must regularly monitor the mix of
fixed-rate and floating-rate assets and liabilities on their balance sheets, as well as when those
assets and liabilities mature or re-price and to what magnitude.
[Max 5]

iii) Issues to be considered in product design / pricing / re-pricing of RDs:

In Recurring Deposits, the customer has to first choose the tenure and monthly deposit amount.
Once the investment starts, the customer must deposit the amount every month over the
tenure. RD interest rates are applied based on the tenure and deposit amount.

Generally, the tenure varies from a minimum of 6 months and thereafter in addition of 3 months
to a maximum tenure of up to 10 years and senior citizens are offered a higher rate of interest.

Product design includes preparing RD terms and conditions which must cover the procedure to
be followed under various scenarios like discontinuance of scheduled deposits, Pre-Matured
Withdrawal (PMW) of RD, revival / renewal of discontinued RDs, any loan facility against RDs, any
TDS (Tax Deducted at Source) applicable etc.

RD opening form should specify minimum amount to be deposited and for higher deposits as
multiples of some whole amounts, lock-in period during which no interest is given on PMW, KYC
(Know Your Customer / Client) documents required, mode of monthly payments like ECS
(Electronic Clearance Service) or online banking or fund transfer etc.

RD Administration systems must be able to cope with the complexity of designs.

A system must exist to pay PMW / maturity amount and record a lot of information about each
RD account such as dates of deposits, corresponding amount deposited, any discontinuance
periods and revivals, RD rates applicable based on RD term structure at the inception of RD
account etc.

The expense loadings must cover the administration costs involved. How to load expenses (both
overhead and marginal) either explicitly like for initial documentation / set up of RD account and
subsequent regular maintenance expenses or implicitly in the margin built in pricing the RD rates
term structure.

Loading of profit margin implicitly in the margin built in pricing the RD rates term structure.
Profitability will be impacted if actual expenses overshoots expenses loaded in pricing the RD
rates.

Page 3 of 15
IAI SA7-1123

The RD rates quoted should be marketable / attractive to prospective RD customers. Addition of

innovative options and guarantees in design features may make RD accounts more attractive like
option to increase / decrease / skip certain number of monthly deposits.

Structure and level of RD rates should be competitive and should not depart too far from those
of competitors, depending on how the bank is going to market it.

Since the market is very price (rate)-sensitive, banks might set expense loading for certain
products that are only slightly greater than that required to cover the marginal costs, thereby
making an apparently insufficient contribution to fixed overheads.

This is then justified because there is still some contribution to expense overheads, as opposed
to the zero contribution, which would result from not selling an uncompetitive product with a
“correct” contribution built in.

What really matters to the bank is the total contribution to overheads (and profit) that results
from selling the product as a whole, not per single account. This total
contribution can be represented broadly by:

total contribution = per-account contribution X number of accounts;

Here the per-account contribution is the profit from a single account net of marginal costs (but
ignoring overhead costs). The bank’s total profit can then be thought of as:

Total profit = total contribution from all types of accounts - overheads

We need to find the level of expense loading that will maximize total contribution from a given
product. In a very competitive market, this is achieved only by having very low per-account
margins thereby ensuring sales. With less competition, higher per-account margins will be
possible without jeopardizing volume

The level of risk that may be acceptable will depend upon the bank’s ability or willingness to
absorb risk. The key risk is Interest Rate Risk (IRR). Other risks include expense overrun and
uncertain behaviour of customers like volatile PMW rates and discontinuance rates.

IRR can be reduced by making the RD rates reviewable periodically, say after every two / three
years. That is not guaranteeing the RD rates for the whole term of the RD account.

Bank may consider using swaps / swaptions to mitigate IRR.

Alternatively, bank could allow cross subsidies across old and new RD accounts while Re-pricing
RD rates for new accounts / customers.

Bank should consider burden of any guarantees not only for maturing accounts but also for
accounts opting PMW and discontinued accounts maturing. For the latter ones, bank may wish to
apply Market Value Adjustments (MVA) to reflect any loss to the bank and apply some penalty
for any liquidity risk taken by the bank.

The burden of PMW on profitability can be assessed by modeling / estimating the association of
PMW rates and interest rates. Unfortunately, interest rate rise (implying fall in asset values) are
related with higher PMW rates.

Page 4 of 15
IAI SA7-1123

Sensitivity of profit: The most important variable that affects profitability is interest rates. Since
RD accounts usually guarantees the accumulation rate for the whole term of the account, any fall
in future interest rates would imply lower earnings on future deposits.

Bank needs to decide on the extent of any cross-subsidies between for example large and small
accounts. The marketing advantage of a simple RD rate structure may conflict with a desire to
avoid cross subsidies. This issue involves expense loadings, what extent should accounts cover
their marginal per-account administrative costs.

Setting expense load fairly that covers cost for RD accounts individually may prove uncompetitive
for small accounts. Bank may set a lower fixed level of per-account expense load, recouping the
difference over all the RD accounts portfolio by a corresponding increase in the expense load
expressed as a proportion of monthly deposit.

Bank must adhere to any regulatory requirements, e.g. maximum (capped) margins in pricing /
re-pricing RD rates, or minimum RD rates, minimum PMW payout etc.

In this regard, regulators may consider maintaining parity between RDs and monthly SIPs
(Systematic Investment Plans) in debt mutual funds investing in government securities only.

Bank should consider how frequently it should re-price or review pricing of RD rates, to bring
them in line with prevailing yields. In addition, consider to re-price if yields change by pre-
specified amount.

For example, re-price frequency quarterly and re-price if yields vary by 0.25% from previous re-
price date. Therefore, monitoring of yields is required on daily/weekly basis to see whether
there is a need to re-price RD rates or not.

Bank can take any of the two approaches for pricing / re-pricing RD rates. First is to apply margins
for expense load and profit in the yield curve itself and then derive RD rates implied by the
reduced yield curve.

Second is to derive gross RD rates implied by the yield curve and then apply margins for expense
load and profit in gross RD rates to get net RD rates for quoting with customers.

In summary, while designing / pricing / re-pricing RDs, the following factors need to be
considered (as discussed above):

Designing Terms & Conditions; Administration systems; Profitability – expense loading and profit
margin; Marketability; Competitiveness; Risk characteristics; Burden of any guarantees;
Sensitivity of profit; Extent of cross-subsidies; Regulatory requirements; Re-pricing or reviewing
RD rates etc.

These factors may not necessarily be independent, meeting one may prejudice the meeting of
another, and so a compromise between factors is required. In addition, the factors are not
necessarily mutually exclusive. Sometimes they will be difficult to resolve.

All other things being equal, simplicity in product design is preferable to complexity.
[Max 10]

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IAI SA7-1123

iv) [(1 + 𝑖)𝑛 − 1]

𝑀=𝑅 −1
[1 − (1 + 𝑖)( 3 ) ]

M= maturity value of RDs;

• R = monthly deposit (installment);
• n = term of the RDs expressed as number of quarters ;
• i = effective quarterly interest rate;
• where, 4i is the RD rate quoted by bank with quarterly compounding

The formula for maturity value of RDs is given by the product of monthly deposit (R) and
accumulated value of annuity due factor (𝑆̈̅̅̅̅̅
3𝑛| ) for term = 3n months with interest rate =
1
(1 + 𝑖)(3) − 1 per month i.e. effective monthly rate.
(1+ 𝑖𝑛𝑡.𝑟𝑎𝑡𝑒)3𝑛 − 1 𝑖𝑛𝑡.𝑟𝑎𝑡𝑒
• 𝑆̈̅̅̅̅̅
3𝑛| = ; Where 𝑑 = (1+ 𝑖𝑛𝑡.𝑟𝑎𝑡𝑒)
𝑑
1 3𝑛
( )
(1+ (1+𝑖) 3 − 1) − 1
(1+𝑖)𝑛 − 1
• 𝑆̈3𝑛|
̅̅̅̅̅ = 1
( )
= −1
( )
(1+𝑖) 3 − 1 1− (1+𝑖) 3
1
( )
1+ (1+𝑖) 3 − 1
[Max 3]

v) The formula for maturity value of RDs can be calculated as the product of monthly deposit (R)
and accumulated value of annuity due factor. However, calculation of accumulated value of
annuity due factor is not straightforward since installments are deposited on a monthly basis and
compounding occurs on quarterly basis.

Moreover, in banks accounts, compounding happens through capitalization of interest at

quarterly rests i.e. compounding at Calendar Quarter (CQ) ends and within a CQ interest is
accrued on a simple interest basis. For simplification, we can assume compounding at RD account
quarterly instead of CQ-ly.

To tackle this, we accumulate the monthly deposits within a RD a/c quarter up to RD a/c quarter
end using simple interest basis and generate a new set of quarterly cash flows that can be
accumulated using accumulated value of annuity arrear factor.

Monthly interest rate = i/3 and accumulated monthly unit deposits in a quarter is given by 1 +
3i/3 + 1 + 2i/3 + 1 + i/3 = 3 + 2i where i = effective quarterly interest rate

Accumulated value of annuity arrear factor for ‘n’ quarters is given by

(1 + 𝑖)𝑛 − 1
𝑆𝑛̅| =
𝑖
The formula for maturity value of RDs (notation used is same as in previous part) is given by

[3 + 2𝑖][(1 + 𝑖)𝑛 − 1]
𝑀=𝑅
𝑖
Page 6 of 15
IAI SA7-1123

[Max 4]

vi) Simple interest used in the derived formula for deposits within compounding period always gives
higher accumulated value than using effective rate accumulation. For example, let the quoted RD
rate be 12% p.a. compounding quarterly. Then i=3% is effective quarterly rate.

Accumulated monthly unit deposits in a quarter using simple interest basis in the derived
formula = 3 + 2 (3.00%) = 3.0600.

Accumulated monthly unit deposits in a quarter using effective interest rate

(1 + 𝑖)𝑛 − 1 (1 + 3%)1 − 1
= −1 = −1 = 3.0598
( ) ( )
1 − (1 + 𝑖) 3 1 − (1 + 3%) 3

Comparing with formula derived above, 3.0600 > 3.0598. Hence, formula derived above will give
higher maturity value for RDs. The formula suggested by team member uses effective rate
accumulation within the compounding period and gives lower maturity value for RDs.
[Max 3]

vii) Order-driven markets

In an order-driven system, there is a rules-based matching system that is used to execute trades
based on orders submitted to the system. Buyers will enter buy orders into an order queue (a
particular quantity at a particular price) and sellers do likewise with their sell orders.

If a buy order specifies a price that is higher than the lowest sell order price in the system, a
trade is executed. Similarly, if a sell order’s price is lower than the highest bid order, a trade is
executed. The systems therefore give priority to the highest priced buy orders and lowest priced
sell orders.

When there are multiple orders at the same prices, precedence is usually given to orders that are
displayed (rather than hidden) and precedence given to earlier orders over later ones, i.e. the
first order submitted at a particular price is filled first.

Order-driven markets can be run by exchanges or by brokerages or by what are referred to as

alternative trading systems. Such alternative trading systems have grown rapidly in the last
decade.

Order-driven markets have the advantage that buyers and sellers are able to see the order book
and decide for themselves whether to trade with an existing displayed order or to enter their
own order and hope it will be executed at a later time.

Types of market order

There are usually a variety of different types of buy or sell orders that can be given – either
directly in the market or indirectly via the intermediary. The most common types of orders are
given below:
• market order – to execute the transaction immediately at the best market price
• limit order – similar to a market order, but limited to a specific high price when buying or
a specific low price when selling
• stop orders – an order to be filled immediately when a specific price trades in the market
• hidden orders – are orders exposed only to brokers which cannot be disclosed to other
traders.

The validity of these orders is also usually specified. The main types of validity are:

Page 7 of 15
IAI SA7-1123

• good-till-cancelled (GTC) – an order that is valid until it is cancelled

• good-till-xxx date – an order that is valid until a specified date and/or time
• fill or kill – an order that has to be transacted immediately in full, or is cancelled
• immediate or cancel – an order that has to be transacted immediately, in part or full,
after which any unfilled parts of the order are cancelled
• good on close – can only be filled at the close of the market
• good on open – can only be filled at the open of the market.

In addition, it is possible to specify whether the trade can be completed in part or whether it
must be completed in full.

For example, if a limit order was specified as being a full order only, then a potential matching
trade must be of sufficient size to complete the whole order. Otherwise, the trade must look
elsewhere for a match, and the limit order will stay on the screen.

If the order is not specified as being full or nothing, then there is the possibility that only a part of
the deal will trade, and the remaining part will appear on the system to be filled.
[Max 7]

viii) Strategy’s Calculations:

Let S be the settlement price of ABC Share at end of 45 days;
Investment horizon is 45 days. Therefore, we can assume every position is cash settled at end of
45 days. For Short put expiring in 15 days, two cases arise.

Case 1: Consider share price < 800 at end of 15 days:

Short put is exercised: we get premium; shares at 800; and dividend 20 per share
= 40 + 20 + (S – 800)

Case 2: Consider share price >= 800 at end of 15 days:

Short put expires worthless: we get premium = 40

Long put = -20 + max (0, 725 – S)

Short call = 50 – max (0, S – 800)
Long call = -30 + max (0, S – 850)

Case 1:
S < 725 Payoff = 40 + 20 + (S – 800) – 20 + (725 – S) + 50 – 30 = – 15
725 <= S < 800 Payoff = 40 + 20 + (S – 800) – 20 + 50 – 30 = S – 740
800 <= S < 850 Payoff = 40 + 20 + (S – 800) – 20 + 50 – (S – 800) – 30 = 60
S > 850 Payoff = 40 + 20 + (S – 800) – 20 + 50 – (S – 800) – 30 + (S – 850) = S – 790

Case 2:
S < 725 Payoff = 40 – 20 + (725 – S) + 50 – 30 = 765 – S
725 <= S < 800 Payoff = 40 – 20 + 50 – 30 = 40
800 <= S < 850 Payoff = 40 – 20 + 50 – (S – 800) – 30 = 840 – S
S > 850 Payoff = 40 – 20 + 50 – (S – 800) – 30 + (S – 850) = - 10

Strategy’s Profitability Range:

For case 1:
• Strategy is profitable when ABC share price is above 740;
• breaks-even at 740; and
• turns into loss making below 740. Lower Breaks-Even Point (BEP) is 740.

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IAI SA7-1123

For case 2:
• Strategy is profitable when ABC share price is below 840;
• breaks-even at 840; and
• turns into loss making above 840 i.e. Upper BEP is 840.
Overall, irrespective of which case (1 or 2) happens at 15 days from now, the strategy gives
profits within the range of 740 to 840.

Beyond this range, it may give limited losses or unlimited gains depending up on case 1 or 2
happens

Strategy’s Maximum profit / loss:

For case 1:
• Maximum profit is unlimited when S>>740
• Maximum loss is 16,500 (= 1100 * 15) when S<=725
For case 2:
• Maximum profit is 841,500 (= 1100*765) when S = 0
• Maximum loss is 11,000 (= 1100 * 10) when S>=850

Maximum profit / loss from case 1 is the maximum profit / loss for the overall strategy since
range of payoff of case 1 includes all payoffs of case 2

Strategy’s Initial capital / margin requirement:

[Link]. Details Amount

1 Long Put = (20)(1100) 22,000
2 Long Call = (30)(1100) 33,000
3 Short Put Case 1 = (800 - 40)(1100) 836,000
Total 891,000
We need to add transaction costs / taxes in the tabulated figure to get the total capital required.
Transaction costs vary from broker to broker.

Short put and short call margins would be in the range of 20% - 40% each, of notional value
880,000 (= (800) (1100)), depending up on expected future volatility of the underlying stock.

Initially, for both short options, margin required is in the range of 352,000 – 704,000, well within
capital required (836,000) to take delivery in case 1.

If case 1 happens, i.e. short put is exercised with physical delivery of shares then there will be no
margin required for short call as it would have become covered call. The shares could be pledged
with the broker as collateral for any margin required in the short call. Moreover, the premium of
short call 55,000 (= (50) (1100)) is held with broker as cash margin.

If case 2 happens, i.e. short put expires worthless, margin requirement would fall in the range
176,000 –352,000 as there will be only one short call option position. This margin can be catered
by 836,000 capital held as contingency for case 1..

Views of a person implementing the strategy:

A person might implement the Strategy if he thinks ABC share price is going to stay close to
current price where profit will be optimal.

He has no directional view i.e. neutral view since he gets profit even if share price rises (falls)
slightly up to upper (lower) BEP.

Page 9 of 15
 IAI SA7-1123

The short put option expiring in 15 days is the only option that is ITM. It seems the person
intends to take delivery of the shares 15 days from now and eat the dividends (as ex-dividend
date is 30 days from now) before closing all positions on day 45.
[Max 10]

ix)
Payoffs S<800 on Day 15 1000; 231
250
Thousands

200

P 150
900; 121
a
y 840; 66
100
o 800; 66 850; 66
f
50 740; 0
f

0 600; -16.5
650; -16.5 725; -16.5
550 650 750 850 950 1050
-50 <------Settlement Price ------>

[Max 5]
[50 Marks]

Solution 2:

i)
a) Information required
1. Provide the trust deed and statement of investment principles for a comprehensive understanding
of the objectives.
2. Furnish financial statements from the past several years for review.
3. Detail any limitations on purchasing or selling specific asset classes.
4. Share existing management arrangements to evaluate potential change costs.
5. Clarify if the trust deed mandates specific holdings, especially the Stellar Electronics Inc.
6. Indicate the total value of trust assets.
7. Outline the current mandates to managers and specifics of the present portfolio.
8. Explain the valuation approach for unlisted assets.
9. Present the current funding status of the trust.
10. Depict the funding pattern over the previous five years.
11. Identify additional revenue sources apart from investment returns, such as regular donor
contributions, and assess their reliability and nature.
12. Provide a breakdown of expenditures, including the total cost per student and whether it covers
textbooks and extracurricular activities.
13. State the current school fee structure.
14. Illustrate the historical and anticipated future school fee inflation.
15. Specify the number of students the trust is responsible for funding and whether this number

Page 10 of 15
IAI SA7-1123

varies.
16. Disclose administrative expenses and other operational costs related to the trust.
17. Clarify the tax status of the fund.
18. Outline any applicable regulatory requirements. [3]

b) Choice of asset allocation:

1. Currency of Liabilities: Understanding the currency of liabilities is paramount. Confirming whether
all schools are located in India or internationally is essential. Investments should align with the
currency of liabilities, even if exclusively INR-denominated, while global equity and bonds offer
diversification advantages.
2. Liability Term: Although the duration of high school education spans around five years, the trust's
perpetual existence allows for the allocation of assets towards higher risk options like equity,
considering the enduring nature of the trust.
3. Taxation Considerations: The tax implications in India should guide the asset allocation strategy,
factoring in income tax and capital gains tax differentials. This helps in crafting a tax-efficient
portfolio.
4. Income Requirements: Given the annual commitment to cover school fees, a consistent income
stream is vital. Projecting future cash flows helps determine the necessary income. Bonds could be
a suitable choice to fulfill this income need.
5. Liquidity Demands: Apart from annual school fee disbursements, funds are required for
administrative expenses. Beyond these obligations, liquidity requirements are modest, enabling
the adoption of a long-term investment approach.
6. Risk Tolerance: Due to the crucial service provided, maintaining a low risk tolerance is imperative.
Avoiding situations where fee payment obligations can't be met is critical. Achieving equilibrium
between real assets for growth and stable assets for secure income is essential. The trust's risk
[3]
tolerance is heavily influenced by its current funding position.

c) Benchmark:
1. The trust's assets should consistently exceed its liabilities to ensure financial stability and meet its
obligations to financially disadvantaged high school students.
2. School and admin fees increase annually with inflation.
3. Bonds (45%): Generate income for yearly fee payments. Mix of government and higher-yield
corporate bonds.
4. Inflation-linked bonds offer inflation-risk protection.
5. Equities (40%, including Stellar Electronics Inc): Preserve trust assets' purchasing power.
6. Global equities (10%): Despite INR liabilities, diversification and exposure to unique sectors.
7. Money market/cash (5%): Liquidity for administration expenses.
8. No allocation to global bonds due to low yields and unwarranted currency risk.
9. Local property could provide increasing annuity income, preferring listed property funds for
liquidity and diversification.
10. In a less favorable funding scenario:
a. Increase allocation to less volatile, income-generating assets like government bonds.
[6]
b. Decrease equity allocation.

Page 11 of 15
 IAI SA7-1123

d) Given all students attend school in India (with liabilities in INR):

1. Understand the trusts objectives – achieving capital growth over the long term and sustaining
educational support.
2. Trustees’ risk tolerance to fluctuations in returns
3. Time horizon – long-term support for students could mean short-term volatility can be tolerated.
4. Assess the potential benefits of equities in achieving long-term capital growth and whether the
trustees are comfortable with the associated risks.
5. Bonds provide income and capital preservation benefits. Evaluate their role in providing stability
to the portfolio and generating cash flow to cover ongoing tuition expenses.
6. Analyze current market conditions, including interest rates and inflation expectations. Higher
interest rates might make bonds more attractive for income, while lower rates might push
investors toward equities for potential returns.
7. Consider the benefits of diversification across asset classes. A balanced allocation can help
mitigate risks and reduce the impact of extreme market movements.
8. Assess the historical correlation between equities and bonds.
9. Regularly rebalancing the portfolio back to the target allocation. This ensures that risk levels and
exposure to different asset classes remain aligned with the trust's goals.
10. Evaluate the yield of the bond component. If the yield is sufficient to cover tuition expenses and
provide stability, it could influence the allocation.
11. Perform stress tests on the portfolio under different economic scenarios. This can help assess the
portfolio's resilience and whether it can continue supporting the educational expenses even
during adverse conditions.
12. Consider how long-term historical trends align with the trust's goals and whether they suggest any
shifts in the allocation.

[5]

ii) a)
1. Stellar Electronics Inc.'s financial health is deteriorating, facing significant challenges.
2. High debt-to-equity ratio, increasing over time, possibly exceeding industry norms.
3. Potential distress borrowing for working capital or dividends.
4. Interest coverage crucial; ability to service interest payments.
5. Need insight into debt nature and access to additional funding.
6. Decreasing sales in real terms, indicating challenges.
[3.5]
7. Declining net profit margin, indicating reduced profitability.
8. Unsustainable trend of dividends surpassing earnings.

b)

1. Essential to review income statement, balance sheet, and cash flow statement.
2. Assess quality of earnings, focusing on cash flow sustainability.
3. Examine Return on Assets (ROA) and its trend to gauge capital efficiency.

Page 12 of 15
 IAI SA7-1123

4. Determine if profit margin is above or below industry average, and its causes like rising input costs
or debt servicing.
5. Analyze future industry and business prospects, considering management, industry, and analyst
viewpoints, as well as Stellar Electronics Inc.'s competitive position.
6. Evaluate management quality and experience in potential turnaround.
7. Ascertain if this marks the cycle's end or if the business is in a terminal decline.
[3.5]
iii) 1. Regular Financial Analysis:
• Continue monitoring the financial condition of Stellar Electronics Inc. by analyzing key metrics
such as sales, net profit margin, dividend payout ratio, and debt/equity ratio.
• Establish thresholds for these financial indicators, triggering a reassessment or potential
divestment if they deviate significantly from historical averages or industry benchmarks.
2. Assessment of Dividend Payout Ratio and Liquidity:
• Given the increasing trend in the dividend payout ratio, assess the impact on the trust's
liquidity and its ability to meet routine expenditures.
• Develop contingency plans for potential liquidity challenges, considering alternative income
sources or adjustments to expenditure planning.
3. Debt Management and Industry-Specific Risks:
• Monitor the rising debt/equity ratio and evaluate the potential impact on Stellar Electronics
Inc.'s financial stability.
• Consider the broader industry-related challenges and assess how these may exacerbate risks
to the trust. Develop strategies to navigate industry-specific risks, such as diversification into
more stable sectors.
4. Scenario Analysis and Distressed Asset Management:
• Conduct scenario analyses based on potential industry downturns or specific challenges faced
by Stellar Electronics Inc.
• Develop a comprehensive distressed asset management plan, outlining specific actions to
mitigate the risk of a 15% asset loss on the trust’s portfolio.
5. Due Diligence on Private Equity Proposal:
• If the buyout-oriented Private Equity (PE) fund's proposal progresses, conduct thorough due
diligence on the fund's reputation, track record, and the specifics of the proposed swap.
• Assess how the trust's interests align with the goals of the PE fund and whether the swap
represents a viable alternative to reduce exposure to Stellar Electronics Inc.
6. Exit Strategies and Legal Considerations:
• Explore exit strategies such as mergers or management buyouts, considering the trust's
position as a controlling stakeholder.
• Potential limitations imposed by the unlisted nature of Stellar Electronics Inc., including
illiquidity, potential high transaction costs, and capital gains tax liability.
• Review the trust deed to understand any restrictions on share sales, possibly due to familial
connections, and seek legal advice on potential avenues for compliance.

[6]

iv) • Establish the legal structure (e.g., limited partnership) of the PEF, as this determines the rights,
obligations, and tax treatment for involved parties.
• Understand the existing investor profile.

Page 13 of 15
 IAI SA7-1123

• Determine the remaining term of the PEF, indicating when the trust can anticipate capital returns.
• Ensure fund objectives align with the trust's ethos.
• Scrutinize the fund's operation, competitive advantages, and exploited market niche.
• Analyze current and projected portfolio composition, diversification by company and sector, and
exit strategies.
• Assess the risks the PEF undertakes, failure percentages, likelihood of achieving hurdle rates, and
anticipated returns.
• Evaluate income distribution from the portfolio; determine if the trust can manage substantial
reductions in income from current Stellar Electronics Inc. levels.
• Ultimately, compare the PEF to shares in Stellar Electronics Inc., considering factors like risk,
nature, cash flow, liquidity, and taxation.
• Examine management credentials, experience, and track record in deal securing and company
management, possibly indicative of future success.
• Investigate the past performance of this fund and comparable funds managed by the same team.
• Review the fee structure encompassing basic fees, hurdle rates, and carried interest, ensuring
their justification.
• Understand the PEF's size and the proportion it would hold in Stellar Electronics Inc.
• Inquire about deal terms:
• For assessing the fairness of the swap ratio.
• Independent/audited valuation of Stellar Electronics Inc.
• Valuation basis for PEF's assets.
• Deal structure (sale and purchase, potential cash payment, timing).
• PEF's interest in Stellar Electronics Inc., evaluating if it aligns with the trust's spirit.
• Consider whether it's an asset-stripping endeavor and its alignment with the trust's ethos.
• Ascertain the PEF's exit strategy for Stellar Electronics Inc.
• Determine the trust's potential participation in PEF's future drawdowns.

[10]

v) a)
• Evidently active through substantial turnover and an atypical portfolio composition.
• Contrarian stance demonstrated by notable performance divergence from the benchmark across
various timeframes.
• Contrarian position, with a notable lack of investment in the IT industry, a major segment of the
Indian market index (Nifty).
• Deviates from benchmark significantly, yielding high tracking error.
• Adopts a value style, featuring low Price-to-Earnings (P/E) ratios relative to the market.
• Exhibits a non-trading approach, with an average holding period of around 4 years, deemed
reasonable. [5]

b) Effective Communication of Investment Performance: Given the diverse backgrounds and expertise
levels of the trustees, clear and meaningful communication is crucial. Visual aids and reports can help
convey information effectively:

• Executive Summary: Provide a concise overview of performance, highlighting key achievements

and challenges.
• Performance Summary Report: Offer a comprehensive report that includes performance metrics,

Page 14 of 15
IAI SA7-1123

risk indicators, and explanations of deviations from benchmarks.

• Graphical Representation: Use line charts to compare the trust's performance against benchmarks
over time. Bar charts can illustrate asset allocation changes.
• Attribution Analysis: Break down the sources of performance by asset class or sector, showing
which components contributed to or detracted from returns.
• Risk Assessment: Visualize risk measures like volatility and drawdowns to help trustees
understand the portfolio's risk profile.
• Narrative Commentary: Include a narrative section that explains investment decisions, changes in
allocation, and market dynamics affecting performance.
• Future Outlook: Discuss future strategies, potential adjustments, and how they relate to the
trust's objectives.
• Peer Group Analysis: Provide a comparison of the trust's performance with a relevant peer group
or similar funds. This can help trustees understand how the trust fares in comparison to others
with similar objectives or strategies.
• Educational Workshops/Seminars: Conduct periodic educational sessions or seminars tailored to
the trustees' level of financial expertise, fostering a deeper understanding among trustees.
• Sensitivity Analysis: Include a sensitivity analysis that demonstrates how changes in key variables
(interest rates, inflation, etc.) may impact the trust's portfolio.
• Social Impact Infographic: Create an infographic that visually represents the positive social impact
of the trust's investments. Use icons, graphics, and concise text to illustrate how the chosen
investment strategy directly contributes to supporting financially disadvantaged high school
students.
[5]
[50 Marks]

**************************

Page 15 of 15
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

20th May 2023

Subject SA7 – Investment and Finance
Time allowed: 3 Hours 15 Minutes (14.45 - 18.00 Hours)
Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions inside the cover page of answer booklet and instructions
to examinees sent along with hall ticket carefully and follow without exception.
2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.
3. Attempt all questions beginning your answer to each question on a separate sheet.
4. Mark allocations are shown in brackets.
5. Please check if you have received complete Question Paper and no page is missing.
If so, kindly get new set of Question Paper from the Invigilator.

AT THE END OF THE EXAMINATION

Please return your answer book and this question paper to the supervisor separately. You are not
allowed to carry the question paper in any form with you.
IAI SA7-0523

Q. 1) You are an ALM (Asset Liability Management) Specialist, working in a commercial bank
XYZ Ltd, mainly responsible for its

 liquidity risk management; and

 derivatives trading management

To assess / monitor liquidity risk, the Banking Regulator has prescribed a liquidity gap
report with the following time buckets for expected future cash outflows and inflows arising
from banking business:

Details 01-14D 15-28D 29D-3M 03-06M 06-12M 1-3Y 3-5Y >5Y

A. Outflows
B. Inflows
Gap = B-A

D=Days; M=Months; Y=Years

A derivatives trader in your team, during the course of a day, shorted 125 futures on ABC
shares. He also took following options positions on the ABC shares whose current price is
INR [Link] net aggregate premiums paid on options (i.e. total paid on longs – total
received from shorts) was zero. All contracts will expire in one day. Each contract (lot size)
has 2000 units. Total payoff, if ABC share price does not move, is INR 500,000.

No. of Calls Strike Price (INR) No. of Puts

Short 100 95 Short 50
Long 125 100 Long 125
Long 10 105 Short 110
Long 35 Calls Net Exposure Short 35 Puts

Your neighbour came to you seeking advice on Pre-Mature Withdrawal (PMW) of a

cumulative (i.e. principal and total interest is paid at maturity) FD (Fixed Deposit) held in
your bank. You learnt from your colleague in FD accounts department that for PMW of FD,
the interest rate will be 0.50% less than the rate effective at the time of deposit for the
duration the deposit was maintained with the bank.

FD Term structure
0 to 1Y 1 to 2Y 2 to 3Y (n-1) to nY
of interest rates
Interest rates in % p.a.
𝑋1 𝑋2 𝑋3 𝑋𝑛
At start of FD
Interest rates in % p.a.
𝑌1 𝑌2 𝑌3 𝑌𝑛
At PMW of FD

Suppose, at start, the FD term was 5 years and 𝑋5% p.a. interest rate would be applicable
for five years provided FD is hold with the bank until maturity. If PMW is done during year
two (or three) then 𝑋2 % - 0.50% (or 𝑋3% - 0.50%) p.a. interest rate would be applicable for
the duration the FD is held with the bank.

i) List typical assets and liabilities found in balance sheet of a commercial bank. (3)

ii) In the context of banking business, define following mentioned risks in one or two
lines:

Page 2 of 4
IAI SA7-0523

 Credit risk
 Liquidity risk
 Margin Risk
 Re-pricing risk (2)

iii) Distinguish between the retail and wholesale banking activities / services provided to
corporate customers. (5)

iv) Discuss in detail the issues or challenges:

 in liquidity risk management of banks; and

 in preparing (or using) the liquidity gap report.

Your answer should consider cash flows related to balance sheet items as well as off-balance
sheet items related to future events / actions. (20)

v) Outline the structural balance sheet ratios used to assess / measure liquidity risk in
banks. (5)

vi) For the derivatives traders’ FnO (Futures and Options) positions on ABC shares,
answer the following:

 determine average price at which the trader shorted 125 futures;

 calculate the total payoffs if share price moves +/- 5% at expiry; and
 comment on the reasonableness of two payoffs calculated above (5)

vii) Discuss on the PMW feature of FDs of the bank. Your answer should include:

 merits / demerits of the PMW feature; and

 suggest suitable changes in the PMW feature to mitigate market risk. (6)

viii) Instead of PMW of FD, which alternative facility available in your bank would you
suggest to your neighbour on existing FD? What other ways / products would you
suggest your neighbour to consider before making any new FDs in future? (4)
[50]

Q. 2) ABC is a life insurance company operating in the country Actuaria. Based on the current
global economic scenario, inflation is a major concern for most economies. As a life
insurance company, the impact of inflation on the ABC’s portfolio can be significant as it
can erode the real value of the company's assets over time, making it challenging to meet
the company's long-term obligations to policyholders. Additionally, as Environment, Social
& Governance (ESG) investing becomes increasingly important, it is also important to
consider the impact of inflation on sustainable investing strategies.

As an Investment Actuary leading the investment team, it is essential to design an

investment strategy that can effectively mitigate the effects of inflation on the company's
assets, while also aligning with the company's ESG goals and achieving its investment
objectives.

Page 3 of 4
IAI SA7-0523

i) What are some of the key investment instruments and techniques that can be used to
manage the impact of inflation on a life insurance company's investment portfolio,
and what are their relative strengths and weaknesses? (10)

ii) How can an investment strategy that incorporates ESG considerations help a life
insurance company mitigate the impact of inflation on its portfolio, and what are some
of the key ESG factors that should be considered? (8)

iii) How can a life insurance company balance the need to effectively manage inflation
risk with the need to achieve its investment objectives and meet the long-term needs
of its policyholders? (12)

iv) How can you ensure that a life insurance company's investment strategy remains
effective in managing inflation risk and aligning with its ESG goals over the long
term, and what are some of the key monitoring and evaluation metrics that should be
used? (10)

v) What are the key risks associated with inflation for a life insurance company's
investment portfolio, and how can they impact the company's ability to meet its long-
term obligations to policyholders? (10)
[50]

*****************************

Page 4 of 4
 Institute of Actuaries of India

Subject SA7-Investment and Finance

May 2023 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates. The solutions
given are only indicative. It is realized that there could be other points as valid answers and examiner have
given credit for any alternative approach or interpretation which they consider to be reasonable.

Page 1 of 13
 IAI SA7-0523

Solution 1:
i) Assets Side:
• mortgages (retail)
• bank loans and overdrafts (retail and wholesale)
• credit card debt (retail)
• interbank deposits (retail and wholesale)
• central bank deposits (retail and wholesale)
• investments in government and corporate bonds (retail and wholesale)

Liabilities Side:
• deposit accounts and term deposits (retail and wholesale)
• interbank borrowing (retail and wholesale)
• secured and unsecured bonds issued (retail and wholesale)
• central bank borrowings (retail and wholesale)
[Max 3]

ii) Credit risk –risk that loans are not repaid or turned into NPAs (Non-Performing Assets)
Liquidity risk –risk that customers do not act independently but panic and want their money
back at the same time
Margin risk –risk that the rate paid for short-term deposits varies while the rate charged on
long-term lending remains fixed
Re-pricing risk occurs when assets (loans and investments) mature or re-price (i.e. interest
rates are reset) at different times than liabilities (deposits and other borrowings)
[Max 2]

iii) The distinction between retail and wholesale activities can be summarised as follows:
Retail Wholesale
High volume Low volume
Low value transactions High value transactions
Large business customers / other financial
Personal customers and small businesses
institutions
Branch networks Branch network unnecessary
High level of competition / lower total costs

Many banking institutions may exist to provide both wholesale and retail services. The
major distinguishing factor is really the value of transactions i.e. the amounts deposited and
loaned.

Services provided by retail banks for corporate customers include:

• provision of overdraft facilities and loans
• cash management schemes
• electronic banking (via EDI, i.e. electronic data interchange)
• leasing and hire purchase
• export and import financing facilities
• international financial transfers
• financial management advice.

Increasingly, these institutions also offer non-banking services (such as fund management)

Page 2 of 13
IAI SA7-0523

Wholesale banks are also known as ‘investment’, ‘merchant’ or ‘Wall Street’ banks. They
are more numerous than retail banks, and of smaller average size. Much of their activity
involves inter-bank transactions and foreign currency business.

The assets of the wholesale banks are dominated by market loans (wholesale loans
atmarket-related rates of interest, usually to other banking institutions) and advances
(lendingmade predominately to the private sector in the form of overdrafts or loans for
fixed periodsof time). Repo transactions also feature prominently.

Banking services provided include:

• taking deposits / making loans on a wholesale basis
• acceptance of Bills of Exchange
• management and underwriting of capital issues by companies (i.e. taking care of
the
issue and sale of bonds on behalf of companies)
• management consulting services (especially with respect to financial aspects)
• advice on mergers and takeovers
• balance sheet advisory
• structured finance
• fund management services (for institutional clients)
• trading in foreign exchange markets
• trading in derivative markets.
[Max 5]

iv) Challenges in managing liquidity risk and in preparing liquidity gap report:
The key issues that are relevant in managing the liquidity risk are:
• Whether the liquidity mismatch (surplus or deficit) for the period under
consideration is within tolerable limits as per the ALM policy of the bank?
• If not, what are the strategies to be employed to ensure that the mismatch is
brought within tolerance levels set?

Banks could remove liquidity risk by matching the duration of assets and liabilities, but this
would also remove their main source of profit from borrowing short and lending long.

Sometimes, even if the liquidity mismatch is within tolerance levels set, the bank may still
implement strategies to get the maximum benefit in a given market environment subject
to adhering to the limits set at all points of time.

This is the active management of liquidity risk in contrast to passively keeping the liquidity
mismatch within limits at all points in time without taking any active position.

There are a number of strategies to managing the mismatch. Typical strategies involve the
use of trading portfolio; refinance facilities and lines of credit available from various
sources, market borrowing, wholesale deposits, securitization -loan sales etc.

Each one of the strategies has to be analyzed in terms of cost and the intended benefit
before a strategy is implemented for managing the mismatch. This is an ongoing process
for the ALM department.

Apart from managing liquidity on a day-to-day basis, as per regulator’s requirements, all
banks are required to produce a Contingency Funding Plan (CFP) to manage stress scenarios

Page 3 of 13
IAI SA7-0523

and to withstand a prolonged adverse liquidity crisis. Action plans based on the CFP must
be established by the ALM to address the situation arising out of the stress situation.

If customers are confident that the bank is sound they are unlikely to all want their money
back at the same time, but if they are worried, they demand their deposits back at the same
time and the subsequent bank run will destroy any bank.

To maintain confidence banks should hold (much) higher levels of capital and that too with
excess liquidity as ‘liquidity buffer’. This is a pool of highly liquid assets that can be sold
quickly to realise cash in case of a bank run.

The most recent bank regulation effectively requires banks to hold a reserve equivalent to
30 days stressed outflows. This approach recognises that if a bank cannot be saved within
30 days it is likely that it cannot be saved at all.

Central banks can help in a liquidity crisis by becoming the ‘lender of last resort’. In doing
so, the central bank must separate liquidity risk from credit risk. If the struggling bank is a
viable ‘going concern’, with sufficient (but illiquid) capital in place to absorb its losses, then
the central bank would provide liquidity - but this help should come at a price.

In order to encourage banks to think carefully before taking more risks in pursuit of profits,
the central bank should charge a high price for its intervention.

Confidence is also preserved by deposit guarantee schemes, but these create moral hazard
as it means banks themselves do not need to be as prudent and expecting to rely less on
their own capital in a crisis.

Government intervention can stop a liquidity crisis by essentially nationalising a bank, Once
the government owns the bank, depositors stop fearing for the return of their money and
the bank run stops.

When a government nationalises a bank, it generally provides share capital (or preference
share capital) rather than loans like central banks. Share capital ranks below depositors and
unsecured creditors; therefore, the government takes a big risk when it does this.

Liquidity risk is categorized into two types; Trading Liquidity Risk and Funding Liquidity Risk.
Trading liquidity risk arises from illiquidity of securities in the trading portfolio of the bank.

As liquidity and return are negatively related, i.e., higher returns can be expected by
accepting an illiquid security over a liquid one, strict policy measures to contain the extent
of illiquidity in the portfolio need to be set up and monitored on a frequent basis.

The funding liquidity risk arises because of mismatch between the timing of cash flow of
the assets from that of the liabilities in the balance sheet

An example of funding liquidity risk let us assume a single asset and a single liability in the
balance sheet of a bank. The asset is a three-year loan and the liability is a six-month term
deposit. The bank would face funding liquidity risk six-months from today when the six-
month term deposit matures for payment since the liability in the form of six-month deposit
would require a cash out flow while the asset would not return any cash flow (ignoring
possible interest flows from the loan) six-months from today.

Page 4 of 13
IAI SA7-0523

This funding mismatch has to be managed by either rolling-over the maturing deposit or
acquiring a fresh deposit or sourcing money in any other way suitable for the bank.

Liquidity gap report is useful for measuring short-term liquidity risk, the net gap (B-A) is the
difference between inflows and outflows. The concept of liquidity gap is simple to
understand but there are few issues:

On assets side:
• Most loans are linked to Prime Lending Rate (PLR) but future dates on which the
rates would be reset is unknown. There are no predetermined reset dates for the
loans and advances linked to PLR
• Whenever PLR changes, the rate on the loans & advances would change instantly
without any time lag whereas for an asset linked to a reference rate, say Treasury
bill rate with a 3-monthreset, we know very clearly that the rate once set for the
asset can change only after3 months and not before that.
• Borrower has Option to prepay in case of Fixed Rate Term loans: the borrowers
may exercise their call option to prepay the loan fully or partially when interest
rates go down as they would be in a position to get the advantage of lower rates
elsewhere.
• Uncertainty of utilisation of OD (Over Draft) limits: a limit is sanctioned for each
borrower and the right to borrow up to the limit is vested with the borrower. Banks
pay a price in the form of uncertainty of timing of utilization by the borrowers of
the unutilized limits as they may be utilized at any time without prior notice.
• As a result of the uncertainty, banks can neither keep the unutilized portion idle as
returns may suffer, nor can deploy it in other assets as the requirement may arise
at any time unexpectedly.
• This problem of banks has been exacerbated by the behaviour of a few large
corporate houses who maintain an unutilized limit and borrow from the money or
capital market as the rate would be cheaper than the lending rate of banks. They
return to the unutilized portion when the market turns tight or the market as a
source of borrowing dry up.
• The assumptions relating to un-availed portion need to be validated based on
behavioural (experience) analysis over a period.
• Cash credit and OD do not have any specific maturity and can result in a cash out
flow at any time so it is difficult to place them in a definite bucket
• Repayment pattern need to be guessed based on statistical analysis of behavioural
(experience) studies as prescribed by regulator
• In the absence of such analysis, the default approach suggested by regulator for
non-maturity deposits maybe used as an alternative
• Major investments are medium to long duration portfolios with low flexibility for
altering Illiquidity structure

On liabilities side:
• Deposits – Savings / Current: don’t have any maturity date; High volatility of
balances in case of current account
• Customer has Option to freely introduce or withdraw money at any time so it is
difficult to place them in a definite bucket
• Interest rates applied are unrelated to market interest rates
• Term Deposits: Cumulative / Non-Cumulative / Recurring: majority are in Fixed
Rates and few Floating Rate (a recent development)

Page 5 of 13
IAI SA7-0523

• Customer Option (put option valuable when interest rates go above the contractual
fixed rate) The right but not an obligation to prematurely terminate the term
deposit at any time during the currency of the deposit.
• This leads to flight of deposits from a bank to its competitor causing an impact on
the liquidity position of the bank.
• The reinvestment risk in case of cumulative deposits
• Some of the maturing term deposits are renewed in the same branch. Such
renewals prevent the outflow of cash thereby reducing the net gap.
• While the renewal behaviour is positive, it is difficult to predict perfectly the
percentage of maturing deposits renewed period after period as the depositor
behaviour may vary from time to time depending on a number of factors.
• If a certain percent of renewal of deposits, say 60% is assumed for the preparation
of the gap reports and the actual renewal is only say 40% for a period, this would
create an unexpected deficit of liquidity which is serious given the nature of
banking business which is heavily dependent upon public confidence.
• Surplus of liquidity would be the result when the actual renewal is higher than the
expected renewal of deposits. While surplus is viewed favourably from the point of
view of the bank’s ability to meet the cash out flows, expected return may suffer as
deploying unexpected surplus may diminish expected return.
• Uncertain instalment payments in case of recurring deposits

The customer exercising options either on the liability side or on the asset side need not
necessarily have an impact on the existing liquidity position when the liability or asset is re-
booked with the same institution at new rates. However, this may affect profit margins.

An experience analysis of the embedded options and their impact on the liquidity position
need to be analysed as they display appreciable variations in terms of geographic region,
the socio-economic profile of the customer, remaining life of the asset or liability, size of
the asset or liability, the extent of change in the market interest rates, etc.

Assumptions relating to off-balance Sheet Items:

• Guarantees provided in favour of customers in various forms like Letters of Credit
etc. are off-balance sheet in nature as liabilities are contingent upon future events.
• A financial or performance guarantee is a non-funded commitment until invoked
by the party in whose favour the bank issued the guarantee.
• Analysis of the timing and magnitude of crystallization of a non-funded
commitment into a funded commitment is extremely important to assess the
impact of such crystallization on the liquidity position of the bank.

Finally, the static nature of the Gap Report: The time taken to compile the report
determines whether it is useful for decision making or not. If time taken is fairly long, then
the first few buckets of information would be useless as the period for which the gaps are
calculated would have simply elapsed.
Even if the time delay is considerably reduced, the dynamic nature of the business of
banking in which a lot of assets and liabilities are contracted on an ongoing basis would
make the figures less relevant in the light of new business, changing behaviour of
customers, etc.

Hence, we should consider planned new business in the form of expected assets and
liabilities in future and the behavioural pattern of customers to take into account the
dynamic nature of the balance sheet.

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IAI SA7-0523

Unless the dynamic nature of positions and behavioural analysis are incorporated into the
analysis of liquidity gap, preparation of a meaningful liquidity report would not be possible
[Max
20]

v) Structural balance sheet ratios are used to assess the liquidity position taking into
consideration the structure of the assets and liabilities in the balance sheet.

• Volatile Liabilities (VL) are payable up to one year

• Temporary Assets (TmA) are investments / receivables within one year
• Earning Assets (EA) = Total assets – (Fixed assets + Balances in current accounts
with other banks + Other assets excluding leasing + Intangible assets)
• Core deposits (CD)= All deposits (including CASA) above 1 year + net worth
• Total assets (ToA)

Measures the extent to which volatile money supports banks’ basic

(VL – TmA) / earning assets. Since the numerator represents short-term, interest
(EA – TmA) sensitive funds, a high and positive number implies some risk of
illiquidity.
Measures the extent to which assets are funded through stable deposit
CD / ToA
base.
Measures the extent of available liquid assets. A higher ratio could
TmA / ToA impinge on the asset utilisation of banking system in terms of
opportunity cost of holding liquidity.
Measures the cover of liquid investments relative to volatile liabilities. A
TmA / VL
ratio of less than 1 indicates the possibility of a liquidity problem.
VL/ToA Measures the extent to which volatile liabilities fund the balance sheet.

• Call borrowing to total borrowing Extent of dependence on call money market for
funding the assets.
• Purchased funds to liquid assets: As purchased funds are volatile to market
conditions, the extent to which they are matched by liquid assets.
• Core Deposits to Core Assets: Extent to which retail deposits are used to fund core
assets such as Loans and approved securities.
• Liquid assets to deposits: Extent of liquid assets available to meet deposit outflows
in an abnormal environment.
[Max 5]

vi) Let X = average price at which the trader shorted 125 futures;
K = Strike Price of option; and
S = Settlement price of ABC share on expiry of the FnOs.
We ignore premiums since net aggregate premiums are zero.

• Here, we will consider only ITM (In-the-money) options and short futures positions to
calculate payoff since for ATM (At-the-money) and OTM (Out-of-the-money) options
payoff will be zero. Payoff for futures is 125(X-S); for ITM Calls is n (S – K); and for ITM
Puts is n (K – S)
• For payoff at S=100 we will consider short futures; K=95 calls and K=105 puts
500,000 = 2000 (125 (X – 100) – 100 (100 – 95) – 110 (105 – 100))
Solving for X, we get X = 110.40

Page 7 of 13
IAI SA7-0523

Payoff at +/-5% means at S=100(1-0.05) =95 and at S=100(1+0.05) =105

• For payoff at S=95 we will consider short futures; K=100 puts and K=105 puts
Payoff = 2000 (125 (110.4 – 95) + 125 (100 – 95) – 110 (105 – 95)) = 2,900,000
• For payoff at S=105 we will consider short futures; K=95 calls and K=100 calls
Payoff = 2000 (125 (110.4 – 105) – 100 (105 – 95) + 125 (105 – 100)) = 600,000
• Net derivatives exposure (excluding hedged options) = 125 short futures; 35 long
calls; and 35 short puts = net 55 short position. Therefore, we expect more payoffs
when share price is low. Thus, payoff at 95 is significantly greater than payoff at
105.
[Max 5]

vii) In FD, amount deposited is locked without any scope of partial withdrawals when needed.
Therefore, if the investor does need the money on an immediate basis, he or she can opt
for PMW or breaking of the fixed deposit.

Merit:
• Current PMW feature is easy to understand and apply.
• Outcomes of all possible cases are well known in advance to both the FD holder as
well as the bank. i.e., both know what is the pay out if PMW is done at any time t <
n.

Demerit:
• Under inverted yield curve scenario at the time of opening FD, it is possible to get
higher interest rate on PMW than what would be applicable if held till maturity.
• The PMW interest rate used does not reflect true or fair MVA (Market Value
Adjustment) that should depend on current FD Term structure of interest rates
rather than those at the start of the FD.
• Use of old interest rates for PMW will lead to gain/loss to the bank; i.e. market
(interest rate) risk in addition to the liquidity risk.

Change required:
• Let P be the principal deposited at start of FD (of term n). At time t < n, PMW occurs
then instead of paying P(1 + X t − 0.5%)t with market risk the bank should value
FD as (ignoring penalty of 0.5%)

(1+ Xn )n
• P (n−t)
(1+ Y(n−t) )

• This formula calculates amount payable at PMW as the original maturity amount
payable at maturity, discounted to current time t, using current FD Term structure
of interest rates.
• This formula removes the market risk to the bank and passes on to the customer.
To account for the liquidity risk, bank may apply a penalty of say 0.5% or 1.0% of
the amount calculated using above formula.
[Max 6]

viii) Loan against FD: Instead of PMW of FD, one can avail loan against FD amount. Bank
provides this facility and charges interest 1%-2% above the interest paid on the deposit.
Banks allow their customers to avail loan up to 90% of their deposit amount. We need to
first compare the costs and benefits of the Loan vs. PMW and select the one that is more
beneficial.

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 IAI SA7-0523

Before opening a new FD compare the costs and benefits of opening a sweep-in account
or FD laddering as explained below:

Sweep-in facility: This facility allows the lender to credit any sum in excess of some amount
stipulated from savings account to a sweep-in account. On opening a sweep-in account, you
are likely to earn a higher interest on the amount deposited to your account. This facility
offers better corpus and ensures immediate cash requirements are met without having to
touch regular investments. Partial or full withdrawals does not attract any penalty
whatsoever.

FD Laddering: FD laddering is a process where you apply for various fixed deposits with
different maturity periods by taking a lump sum amount and dividing them into smaller
investments to open multiple fixed deposit accounts.

For example, if you have a lump sum amount of Rs.5 lakh, you can invest it in five different
smaller FDs with maturity periods ranging between one year and five years. In this way, you
will not only have long-term fixed deposit accounts, but also short-term accounts, for
liquidity.

The laddering process helps to meet your immediate financial requirements without any
need for PMWs. Even if you need to PMW money, it will be only to the extent of the amount
you will need. For example, if you need an amount of say Rs.2 lakhs, you can prematurely
withdraw Rs.1 lakh each from two of your FD account. While you may have to pay a penalty
for those two accounts, the remaining ones will continue to fetch you interest on your
deposits. You can then choose to reinvest on maturity so that you can increase your cash
flow.
[Max 4]
[50 Marks]

Solution 2:
i) 1. Inflation-Linked Bonds: These bonds offer protection against inflation as the interest
rate is adjusted based on inflation levels. They are a useful tool in managing inflation
risk, but their returns may be lower than nominal bonds.
2. Commodities: Investing in commodities such as gold, oil, and natural gas can provide a
hedge against inflation. However, their returns may be volatile and subject to supply
and demand shocks.
3. Real Estate: Real estate investments can provide an inflation hedge as rents and
property values tend to rise with inflation. However, they may be subject to market
fluctuations and are not always easily liquidated.
4. Infrastructure: Infrastructure investments such as toll roads and airports can provide a
hedge against inflation as they are linked to economic growth and inflation. However,
they may require significant capital expenditure and are subject to regulatory and
political risks.
5. Treasury Inflation-Protected Securities (TIPS): These bonds offer principal and interest
rate adjustments to compensate for inflation. They are a useful tool in managing
inflation risk, but their returns may be lower than nominal bonds.
6. Inflation-Indexed Annuities: These annuities offer a guaranteed income stream that is
adjusted based on inflation levels. They can provide a hedge against inflation, but their
returns may be lower than other annuities.
7. Equity Investments: Investing in companies that are expected to benefit from inflation,
such as those in the natural resources sector, can provide a hedge against inflation.
However, their returns may be subject to market fluctuations and risks.

Page 9 of 13
IAI SA7-0523

8. Floating-Rate Debt: These bonds offer an adjustable interest rate that can provide
protection against rising interest rates and inflation. However, their returns may be
lower than nominal bonds.
9. Foreign Currency Investments: Investing in currencies that are expected to appreciate
with inflation, such as those of emerging market economies, can provide a hedge
against inflation. However, they may be subject to exchange rate risk and geopolitical
risks.
10. Private Equity: Private equity investments in companies that are expected to benefit
from inflation, such as those in the energy and natural resources sectors, can provide a
hedge against inflation. However, they are illiquid and require significant capital
expenditure.
11. Short-term Debt: Investing in short-term debt instruments such as commercial paper
can provide a hedge against inflation. However, their returns may be lower than
nominal bonds.
12. Inflation-Linked ETFs: These exchange-traded funds invest in a basket of inflation-linked
bonds and can provide a hedge against inflation. However, their returns may be lower
than nominal ETFs.
13. Inflation Swaps: These derivative instruments can provide protection against inflation
by allowing the transfer of inflation risk between parties. However, they are complex
and may be subject to counterparty risk.
14. Inflation Derivatives: These derivative instruments can provide protection against
inflation by allowing the transfer of inflation risk between parties. However, they are
complex and may be subject to counterparty risk.
[Max 10]

ii) 1. Incorporating ESG considerations into the investment strategy can help to identify and
manage long-term risks associated with inflation.
2. By investing in sustainable companies with strong ESG practices, the company can
potentially achieve better returns in the long run, as these companies tend to be more
resilient to economic and market downturns.
3. ESG investing can help to diversify the company's portfolio and reduce its exposure to
certain industries or sectors that may be more vulnerable to inflationary pressures.
4. Companies with strong ESG practices may be better equipped to manage the impact of
inflation on their operations and supply chains, reducing the risk of disruption to their
business and ultimately benefiting their investors.
5. Investing in ESG-focused funds or ETFs can help to increase the overall ESG profile of
the company's portfolio and align with its sustainability goals.
6. One key ESG factor to consider is climate change, which can have significant long-term
implications for the economy and financial markets.
7. Environmental factors such as water scarcity, deforestation, and pollution can also have
a significant impact on the economy and should be considered in the investment
strategy.
8. Social factors such as labor practices, human rights, and community engagement can
also affect the long-term sustainability of companies and should be considered in the
investment process.
9. Governance factors such as board composition, executive compensation, and
shareholder rights can also impact a company's long-term success and should be
evaluated in the investment process.
10. Assessing the carbon footprint and energy efficiency of the companies in the portfolio
can help to identify potential risks and opportunities related to energy prices and
climate change.

Page 10 of 13
IAI SA7-0523

11. Investing in companies with strong ESG practices can help to reduce reputational risk
for the life insurance company, as these companies are less likely to be associated with
controversies or scandals.
12. Incorporating ESG considerations can help to attract and retain customers who are
increasingly concerned about sustainability and social responsibility.
13. By investing in companies that are aligned with its ESG goals, a life insurance company
can also help to support positive social and environmental outcomes.
14. Active engagement with portfolio companies on ESG issues can help to promote better
corporate practices and reduce risk for the life insurance company.
15. Regular monitoring and reporting on the ESG performance of the portfolio can help to
ensure that the investment strategy remains aligned with the company's long-term
sustainability goals.
[Max 8]

iii) 1. A life insurance company can balance the need to manage inflation risk with its
investment objectives by developing a comprehensive investment strategy that
considers both factors.
2. The company should establish clear investment goals and a risk management
framework to guide its investment decisions.
3. The investment strategy should take into account the company's risk appetite,
investment horizon, and the nature of its liabilities.
4. The company should consider diversifying its portfolio across different asset classes,
such as equities, fixed income, and real assets, to reduce the impact of inflation on its
assets.
5. The company should consider investing in inflation-linked securities, such as TIPS or
inflation-linked bonds, to provide a hedge against inflation.
6. The company should regularly monitor and adjust its investment strategy to reflect
changes in the economic and market environment.
7. The company should consider partnering with investment managers with expertise in
managing inflation risk to help design and implement its investment strategy.
8. The company should evaluate the cost and effectiveness of different hedging
strategies, such as interest rate swaps or options, to manage inflation risk.
9. The company should consider the impact of inflation on its investment returns, as well
as on its liabilities, and adjust its asset-liability management strategy accordingly.
10. The company should regularly assess its liquidity needs to ensure that it has sufficient
funds to meet its obligations to policyholders in a timely manner.
11. The company should consider the impact of inflation on its capital position and ensure
that it has adequate capital reserves to withstand inflationary pressures.
12. The company should consider the impact of inflation on its policyholder base and adjust
its product offerings and pricing strategy accordingly.
13. The company should consider the impact of inflation on its distribution channels, such
as its sales force and marketing strategy, and adjust these as needed.
[Max 12]

iv) 1. Establish a clear investment philosophy and strategy that considers both inflation risk
and ESG factors, including the company's risk appetite and investment objectives.
2. Develop an appropriate asset allocation strategy that considers the risk-return trade-
off, the company's liabilities and cash flow requirements, and the impact of inflation
and ESG factors.
3. Identify and analyze asset classes that provide potential inflation hedging benefits, such
as inflation-linked bonds, real estate, and commodities.

Page 11 of 13
IAI SA7-0523

4. Conduct thorough due diligence on potential investments to ensure they align with the
company's ESG goals and are consistent with the investment strategy.
5. Implement a robust risk management framework that includes stress testing, scenario
analysis, and risk monitoring tools to identify potential risks and mitigate them
effectively.
6. Regularly review and adjust the investment strategy as market conditions and the
company's risk profile evolve.
7. Ensure that the investment strategy is consistent with the company's overall financial
and business strategy and is approved by senior management and the board of
directors.
8. Establish appropriate performance benchmarks and evaluate investment performance
regularly against these benchmarks.
9. Monitor the portfolio's liquidity and cash flow requirements to ensure that the
company can meet its obligations to policyholders.
10. Monitor the impact of inflation on the company's investment returns, assets, and
liabilities regularly.
11. Measure the company's ESG performance and track progress against established
targets and industry standards.
12. Conduct periodic external reviews of the investment strategy and performance to
ensure it remains relevant and effective.
13. Ensure that the investment team is appropriately trained and resourced to manage the
portfolio effectively and monitor inflation risk and ESG factors.
14. Maintain effective communication and collaboration with key stakeholders, including
policyholders, regulators, and investors.
15. Regularly report to senior management and the board of directors on the investment
strategy, performance, and risk management.
[Max 10]

v) 1. Inflation can erode the real value of a life insurance company's assets over time,
reducing their purchasing power and making it challenging to meet long-term
obligations to policyholders.
2. Increase the company's liability amounts, as policyholders may require higher benefits
to maintain their standard of living.
3. Increased investment volatility, making it difficult to accurately predict future
investment returns and meet policyholder obligations.
4. Reduce the value of fixed income securities, such as bonds, which are a key component
of a life insurance company's investment portfolio.
5. Increase the cost of living, leading to higher claims payouts and potentially reducing the
company's profitability.
6. Lead to higher interest rates, which can reduce the value of existing fixed income
securities and increase the company's borrowing costs.
7. Decline in the value of equity securities, such as stocks, as companies may struggle to
maintain profits and dividends in a high inflation environment.
8. Increased competition for resources, such as labor and materials, which can increase
costs for the company and potentially impact its profitability.
9. Currency fluctuations, which can impact the value of the company's foreign
investments and potentially increase the cost of imports.
10. Changes in government policies and regulations, which can impact the company's
investment portfolio and profitability.
11. Changes in consumer behavior, such as increased saving and reduced spending, which
can impact the performance of the company's investment portfolio.

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IAI SA7-0523

12. Changes in interest rate policies by central banks, which can impact the value of the
company's fixed income investments.
13. Changes in global economic conditions, such as recessions or booms, which can impact
the performance of the company's investment portfolio.
14. Changes in industry-specific conditions, such as increased competition or changes in
technology, which can impact the profitability of the company's investments.
15. Changes in investor sentiment, which can impact the performance of the company's
investment portfolio and potentially reduce the company's ability to raise additional
capital.
[Max 10]
[50 Marks]

*********************

Page 13 of 13
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

3rd December 2022

Subject SA7 – Investment and Finance
Time allowed: 3 Hours 15 Minutes (14.45 - 18.00 Hours)
Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions inside the cover page of answer booklet and instructions
to examinees sent along with hall ticket carefully and follow without exception.
2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.
3. Attempt all questions beginning your answer to each question on a separate sheet.
4. Mark allocations are shown in brackets.
5. Please check if you have received complete Question Paper and no page is missing.
If so, kindly get new set of Question Paper from the Invigilator.

AT THE END OF THE EXAMINATION

Please return your answer book and this question paper to the supervisor separately. You are not
allowed to carry the question paper in any form with you.
IAI SA7-1222

Q. 1) A pension fund company XYZ Ltd., established two years ago, takes contributions from
members of Defined Contribution pension Schemes (DCSs). It offers three types of
investment funds as shown in table below:

Fund Name Debt Allocation Equity Allocation MF

Salad 85% - 95% 5% - 15% 0.50%
Sauce 65% - 75% 25% - 35% 0.75%
Steak 50% - 60% 40% - 50% 1.00%

MF - Management Fee as % p.a. of AUM (Assets Under Management) is applied on daily

basis. MF is the only fee charged by XYZ i.e. no entry/exit loads.

Four fund switches per year among the funds is allowed free of cost. On any day, a fund
switch request received from a member is performed on the next day’s fund NAVs (Net
Asset Values).

Equities fell a lot and remained low for most of the time in past one year. Last year fund
returns were negative across pension fund industry. XYZ fund performance came in lower
quartile compared to its competitors. Consequently, few DCSs have withdrawn all their
funds. To tackle this issue, XYZ is considering two steps:

I. Introduce Specialist Asset Classes (SACs) like Hedge funds and Managed Futures
funds to enhance returns. SACs (or Alternative Investment Funds; AIFs), as an asset
class, are used by most of the competitors whose performance came in top quartile. AIFs
will replace a portion of Equity allocation to the extent of 0% - 5% in Sauce fund and
5% - 10% in Steak fund. For investing in AIFs, XYZ is assessing two Managed futures
fund traders.

First trader uses Stop orders via Algorithmic trading to trade in equity index futures. She
has a trend-following trading plan as stated below.

 Enter into a trade (long/short) when market breakouts (up/down side) occur during
a consolidation (markets moving sideways) phase.
 Exit the trade on trend reversal.

Second trader is a non-directional (no-trend) trader who uses stock (equities) options. His
options strategy is similar to the following example:

ABC Ltd. share has recently rallied from 600 to 700 in last month upon beating the market
expectations in quarterly earnings. Post rally, in the past two weeks, ABC share is moving
sideways in the range 684 – 720 and is expected to be trading in range bound manner for
coming two months. He takes options long/short positions to hold until expiry of a one-
month on ABC shares. Contract (Market lot) size is 1200 units.

Strategy

Long a European put at strike price 600 (option premium = 10).

Short a European put at strike price 650 (option premium = 20).
Short a European call at strike price 750 (option premium = 25).
Long a European call at strike price 800 (option premium = 15).

Page 2 of 5
IAI SA7-1222

II. Introduce investment guarantee: Launch three funds similar to existing funds with
PNG (Purchase NAV Guarantee) applicable for all contributions in to PNG funds
(namely PNG Salad; PNG Sauce and PNG Steak). On partial/full withdrawal of funds
by a member, current NAV of units from each contribution is compared with its PNG.
Any shortfall is made good by XYZ.

Partial withdrawals and fund switches are done on FIFO (First-in-First-Out) basis. For all
three PNG funds, MF is increased by 0.25% p.a. as Investment Guarantee Charge (IGC).

See table below for sample calculations; for a member with two contributions of 1000 each
at NAVs 10 and 20. 𝑃𝑎𝑦𝑜𝑢𝑡 = ∑2𝑖=1 𝑈𝑖 𝑀𝑎𝑥(𝑃𝑁𝐺𝑖 ; 𝑁𝐴𝑉3 )
= 100 𝑀𝑎𝑥(10; 15) + 50 𝑀𝑎𝑥(20; 15) = 100 (15) + 50 (20) = 2500
Final payout = 2500 with shortfall of 250 paid from XYZ pocket.

Year Contribution NAV PNG Units Total Units Fund Value

1 1000 10 10 100 100 1000
2 1000 20 20 50 150 3000
3 Full withdrawal 15 NA -150 0 2250

i) List forms of SACs/AIFs that XYZ could consider for enhancing returns. (3)

ii) Mention key differences between Hedge funds and Managed futures funds. (2)

iii) Write a short note on Algorithmic trading. (5)

iv) Discuss the usefulness of stop orders in executing the trading plan of the first trader (in
an order driven market structure). (5)

v) Plot a rough diagram for the second trader’s options strategy that shows the total payoff
against the settlement price of the share (over a range 500 – 900). On the diagram, show
the values of turning (kink) points and break-even points. (5)

vi) Suggest whether to employ first trader or second trader or both along with any
modifications required in trading approach. (5)

vii) Mention the merits and demerits of introducing the PNG guarantee. (8)

viii) Suggest ways to modify the proposed PNG guarantee structure, which addresses the
demerits stated by you. (5)

ix) Discuss in detail the ALM process to determine investment guarantee charge for the
PNG funds. Your answer should include both approaches: deterministic and stochastic. (12)
[50]

Q. 2) Pension Regulator of a developing economy intends to set standards in the financial literacy
of Retirement Advisors who offer pension schemes’ products as part of financial planning
to potential subscribers.

List the key topics/concepts to be included in the curriculum of Retirement Advisors

Certification Examination. [15]

Page 3 of 5
IAI SA7-1222

Q. 3) In a developing country, the regulations require each employee of the company to be

provided with post retirement corpus which by nature is defined contribution but on
smoothed basis. In this arrangement, the plan sponsor is the participant in the smoothed
bonus fund underwritten by regulated insurers. Only large cap sponsors are allowed to offer
such plans to their employees. Company once becoming large cap (market capitalisation
more than 500 crore) will remain large cap for this purpose till perpetuity.

The funds offered for this purpose have the typical features of a smoothed bonus fund with
some elements customised to meet the specific needs of the plan and to manage the risks to
the insurer.

As per regulations, the contributions to the fund are made in proportion to fixed salary
deducted from gross pay every month and is tax deductible. The withdrawals of plan
members can occur only on retirement (age 60), termination or leaving of service or on
death. In all cases the accumulated corpus of the member is paid by the plan by withdrawing
equivalent amount from the fund. All contributions are required to be paid into the fund
within 24 hours of deduction from salaries and no other withdrawal can be made by plan
sponsors.

The investments are made by insurers on a segregated basis for each plan/corporate fund
and may have different charging and bonus sharing structures basis the requirement of the
plan. The fund operates on reversionary bonus philosophy with reversionary bonuses paid
every anniversary with no terminal bonuses being paid. The reversionary bonus once
declared cannot be reduced. The reversionary bonus is based on 10 yrs. G-sec rate with
minimum guarantee of 3%. The G-Sec has been hovering between 5-10% for the last two
decades. There is no sharing of demographic risk with employees and any shortfall/surplus
remain within the fund and risks born by plan sponsor and insurer in same ratio as profit
sharing.

However, following the run off the remaining fund is shared back with the plan sponsor
using the same sharing formula.

The reversionary bonuses for fund are paid on accumulated benefits each year using the
following formula:

 Reversionary Bonus for fund (t) = [Fund after bonus at previous anniversary
*reversionary bonus declared (t)] + [∑contributions during year * reversionary
bonus(t)* fractional year] – [∑withdrawals during year * reversionary bonus(t)*
fractional year]

Last two terms relate to partial bonus credited and debited for contributions and withdrawals
during the year.

 Fund for regulatory purposes = [Fund after bonus at previous anniversary +

Reversionary Bonus for fund + ∑contributions during policy year] – [∑withdrawals
during policy year]

For the employee the accumulated fund for benefit payment is given as:

 Reversionary Bonus amount for member (t) = [Fund after bonus at previous fund
anniversary *reversionary bonus declared (t)] + [∑contributions during year *
reversionary bonus(t)]
Page 4 of 5
IAI SA7-1222

 Fund for benefit of employment termination = Fund after bonus at previous fund
anniversary + Reversionary Bonus amount for member.
 no partial withdrawal allowed for the employee and full payment made on specific
employment terminations described above.

The regulations requires that insurers expenses cannot be more than 1.5% of the fund in any
year taking into account timing of contributions and withdrawals. The profit sharing cannot
be more less than 80% of the regulatory surplus.

The regulatory surplus is defined as market value of assets less smoothed fund value at end
of policy year. The withheld surplus is required to be invested in the fund and can be shared
post runoff. However, if the regulatory surplus is negative, the same is required to be funded
by plan sponsors and insurers in same proportion as the profit sharing. E.g. if profit sharing
is 90:10 and there is a shortfall of 100 crores, then 90 crores will be funded by plan sponsors
and 10 crores by insurer.

Note: Regulatory surplus is a mechanism to determine surplus/deficit and contribution

required and to some extent reflect the combination of all risks. However, the benefit
determination is independent of any regulatory surplus/deficit and is based on G-Sec rates.

Therefore, the only income earned by insurer is investment expenses and profit share at run-
off.

i) Discuss the benefits and drawbacks of such a segregated investment vehicle for the post
retirement plan rather than participating in a similar fund that is pooled with other
retirement plans offered by insurer. (5)

ii) Identify the risks to the insurer in offering such product in the market and how it can
alleviate some of these risks. (5)

iii) Identify the risks to the plan sponsors for this arrangement and how it can alleviate
some of these risks. (5)

The portfolio of assets for this smoothed bonus fund is invested 30% in equities and 70% in
fixed interest instruments. Recently there is a severe fall in the value of the equity market,
the smoothed bonus fund is left considerably underfunded.

iv) Describe how the equity market fall has affected the stakeholders by this underfunded
position. (10)

v) Discuss the actions, other than changing benefits or contributions, that could be
considered by the pension plan or the insurer in order to:

a) alleviate this funding shortfall in the short term.

b) reduce the possibility of such funding shortfalls occurring in the future. (10)
[35]

******************

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IAI SA7-1222

Institute of Actuaries of India

Subject SA7-Investment and Finance

December 2022 Examination

INDICATIVE SOLUTION

Introduction

The indicative solution has been written by the Examiners with the aim of helping candidates. The solutions
given are only indicative. It is realized that there could be other points as valid answers and examiner have
given credit for any alternative approach or interpretation which they consider to be reasonable.
IAI SA7-1222
Solution 1:

i) Real estate funds; Private equity funds: Venture capital / Restructuring capital in Distressed
securities; Credit investment funds; Hedge funds; Commodities; Securitisations: Asset backed
securities; Structured products
[0.5 per each] [Max 3]

ii) Managed futures funds are similar to Hedge funds in most aspects like actively managed; high
leveraged; incorporated as limited partnerships and similar fee structures. The key difference is
that:
Hedge funds are more active in cash / spot markets and use futures and options for hedging
Managed futures funds trades exclusively in derivatives like futures and options
Managed futures funds are more regulated than hedge funds in some places
They have different legal and tax standards
[1 per point] [Max 2]

iii) Algorithmic trading is automated computerized electronic trading based on quantitative rules in
the form of algorithms. On order driven markets, it enables execution of multiple orders
simultaneously.

When it is used for dealing and execution only – the algorithms are usually referred to as execution
algorithms or just algorithmic trading.

It is used to reduce costs and risks associated with the dealing and execution of trades. It enables
traders SOR (smart Order Routing) to locate and place orders in the exchanges with best real-time
liquidity.

It minimizes market impact and help achieve an execution price as close to the market price as
possible. It also disguises the large trades by making it into smaller pieces to stop other market
participants benefitting from any knowledge about another participant's desired trades.

When algorithmic trading is used for trading with the aim of making trading profits, it is usually
referred to as High Frequency algorithmic Trading (HFT), or quantitative trading.

Computers use execution management systems for complex event processing (CEP) of high
frequency databases to scan the volumes of buy and sell offers on the screen much more quickly;
assess the direction of new orders very quickly, and then act on the information in seconds.

A significant challenge for Algorithmic trading is latency - the time difference between order
generation and execution. Low latency is essential to prevent other market participants with the
fastest market access gaining a first-mover advantage and placing orders ahead of one's own. A
significant and ongoing investment in technology and research may be needed to remain
competitive.

There is a danger of a market participant reverse-engineering another participant's algorithm and

taking advantage of any knowledge gained. This has changed the role of traders into strategists
and tacticians.
[1 per point] [Max 5]

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IAI SA7-1222
iv) Stop order is an order to be filled immediately when a specific price trades in the market. For stop
loss buy (sell) order to cover existing short (long) position, this trigger price should be higher (lower)
than current market price.

Stop-loss orders are critical when we cannot actively keep an eye on the market to protect us from
sudden market news, data releases etc. that is unfavourable to our existing position.

Stop-loss orders can also be used to take new positions when sudden market news’s impact on
prices, either good or bad, is not instantaneous but happens slowly in a trending fashion.

Suppose, currently we have no position and market is in consolidation phase, i.e. market is moving
sideways in a range. We are not sure of the direction of breakout but believe that it will break out
of this range ultimately (on arrival of sudden market news) and move significantly higher (lower)
forming an up (down) trend. In this case, two stop-entry orders can be used to get into the market
in the direction of breakout.

For example, the Nifty index future is trading in a consolidation phase i.e. moving in a sideways
range between 17000 and 17200 for some days. We could place two stop-entry orders:
 one above the current range high of 17200—say at 17250 and
 another below the current range low of 17000—say at 16950
to allow for a margin of error—to get into the market once the sideways range is strictly broken to
the up (down) side.

Once either of the order is executed, we would adjust the remaining order in the direction of the
trade using a trailing stop-loss. Finally, our position is closed by the trailing stop-loss order, taking
 limited loss if the breakout turns out to be a false one or
 maximum gains if the breakout turns out to be a significant/sustained trend.

Stop orders help to restrict losses in existing positions but do not guarantee that losses would not
be worse than expected. On volatile days where price gaps occur with widening bid-offer spreads,
actual execution price may be worse than the price we are looking for.

In some markets, all stop orders are cancelled by exchanges where the price gaps are more than a
threshold level. In such cases, the trader has to place another stop/limit order immediately to cover
his existing positions.
[1 per point] [Max 5]

Page 3 of 14
IAI SA7-1222

v) Payoff diagram

Payoffs of Iron Condor

30 650; 24 750; 24
Thousands

20

10
P
630; 0 770; 0
a
0
y
450 500 550 600 650 700 750 800 850 900 950
o -10
f <------Settlement Price ------>
f -20

-30 500; -36 600; -36 800; -36 900; -36

-40
[Max 5]

vi) Equity markets could be in uptrend or consolidation / sideways or in down trend. Holding of
equities will give positive (negative) returns in uptrend (down trend) but will give close to zero
returns in consolidation phase. We have to consider whether to replace a portion of equity
allocation to the two traders is beneficial or not.

We can employ both traders subject to regulatory approvals/admissibility, as they have potential
to deliver positive returns when XYZ’s equity holdings doesn’t give positive returns
 first trader in down trend; and
 second trader in consolidation phase

Modifications to first trader:

 Trade more quantity in down trends and less (or nil) in up trends
 For stocks in the top five / ten of XYZ’s equity holdings, instead of trading in index futures,
trade in the stock futures.
 For other small equity holdings, use appropriate hedge ratio at portfolio level, when
determining quantity to be traded in index futures.

Modifications to second trader whose options strategy has limits on maximum profit/loss:
 Instead of holding options positions till expiry, close all positions to avoid gamma risk close
to expiry; exit when X% (say 75% - 95%) of maximum profits is achieved; and roll over the
option strategy for next month
 Use stop loss for the options strategy and exit when Y% (say 55% - 75%) of maximum loss
is achieved; i.e. don’t wait for the wrong trade to consume full maximum loss of the
strategy
 For XYZ’s small equity holdings, use appropriate hedge ratio at portfolio level, to determine
quantity of index options instead of trading in stock options.
[1 per point] [Max 5]

Page 4 of 14
IAI SA7-1222

vii) Merits of introducing the PNG guarantee

 XYZ can get more business as it will be attractive for potential DCSs as the members feel
that their capital will be safe
 get planned new business at lower marketing costs than required earlier
 retain funds of existing DCSs by allowing them to switch in to PNG funds
 XYZ can make more profits over the long term from any margins in investment
guarantee charges (IGC) left in excess of any shortfalls expected to be paid when the
PNG guarantees will bite
 FIFO basis for partial withdrawals will protect XYZ; say for e.g. in year 3 in sample
calculations; instead of full withdrawal if there was a partial withdrawal of 900 (= 60(15))
60 units from first contribution will be used.
 Otherwise, on pro-rata basis of 2:1 (1500:750); 600 (= 40(15)) 40 units from first
contribution and 300 (= 15(15) + 75) 15 units from second contribution along with a
shortfall of 75 would be taken as loss.

Demerits of introducing the PNG guarantee

 Having same IGC of 0.25% p.a. for all three funds doesn’t seem justifiable given that
they have different risks due to varying equity exposure
 XYZ can make huge losses when IGC is not sufficient to meet any shortfalls when the
PNG guarantee bites
 Even with FIFO basis, suppose instead of 900 partial withdrawal in year 3 there was a
partial withdrawal of 2000; 1500 (= 100(15)) 100 units from first contribution and 500
(= 25(15) + 125) 25 units from second contribution along with a shortfall of 125 would
be taken as loss i.e.
o Usually, latest contributions have higher chance of PNG guarantee being in-the-
money (unless later contributions came in bottom of a recession!);
o FIFO basis cannot protect from guarantee biting for higher amount of partial
withdrawals as it will eat up earlier contributions quickly
 We are not sure whether members would appreciate the fact that PNG guarantee is
more beneficial to them and not same as capital guarantee.
 For e.g. in sample calculations, we see that even though the fund value (2250) is more
than total contributions (2000), the guarantee is biting with a shortfall (250).
 As four fund switches are allowed per year, administering the members fund and
guarantee data would be very difficult if they move from PNG funds to non-guaranteed
funds and then back to PNG funds and if we treat switch from non-guaranteed funds to
PNG funds as fresh contribution, then guarantee cost would increase significantly
 This fund switching is a problem even if switches occur among PNG funds where we
have to maintain the guarantee level; i.e. if a guarantee is in-the-money prior to switch
it should also be so post switching to the same extent:

𝑂𝑙𝑑𝑃𝑁𝐺
𝑁𝑒𝑤𝑃𝑁𝐺 = 𝑂𝑙𝑑𝑁𝐴𝑉 (𝑁𝑒𝑤𝑁𝐴𝑉)

 For example, in sample calculations, suppose instead of full withdrawal in year 3 there
was a full fund switch (partial fund switch upon multiple switching to and fro between
two PNG funds is more complex process with FIFO) in to another PNG fund at current
NAV of 30
Year Contribution NAV1 PNG1 Units1 NAV2 PNG2 Units2
1 1000 10 10 100 NA 20 50
2 1000 20 20 50 NA 40 25
3 Switch 15 NA -150 30 NA

 Operational risk with Day2 features: in administering FIFO along with fund switches; to
do manually is a tedious process and more prone to mistakes where more than required
Page 5 of 14
IAI SA7-1222
value paid to members cannot be recouped
 Automating PNG feature in the admin system and testing at unit /functional level; doing
UAT by preparing test cases covering all possible combinations is a challenging task
[1 per point Max 3 (5) for merits (demerits)] [Max 8]

viii) Ways to modify proposed PNG guarantee structure

 Perform ALM exercise to determine appropriate IGC for the three PNG funds
 If IGC comes out to be very high for PNG steak fund that has highest equity allocation,
consider skipping the PNG guarantee for this fund since members opting Steak fund
have high risk appetite
 Introduce a lock-in-period of say 3 to 5 years post which PNG guarantee gets activated
on each contribution since latest contributions have higher chance of PNG guarantee
being in-the-money. Use longer lock-in-periods for funds with higher equity allocation
 Introduce cap on amount of partial withdrawals (say 20% of fund value) that can be
made in a year since FIFO basis cannot protect from guarantee biting for higher amount
of partial withdrawals
 If members perceive PNG guarantee as capital guarantee then replace PNG guarantee
with capital guarantee that will be less onerous. In capital guarantee, growth of past
contributions can be used to offset any shortfalls from recent contributions directly
entering in to market fall whereas in PNG guarantee each contribution’s capital
guarantee is to be met by itself or from XYZ pocket.
 Once switched out of guaranteed funds to non-guaranteed funds do not allow switch
back in to guaranteed funds.
 Do not allow fund switches among PNG funds to remove complexities of applying FIFO
and need to maintain guarantee levels; or limit the number of switches allowed, say to
one or two per year.
 To avoid operational risks, though a challenging task, it is better to automate the admin
systems for all fund transactions before launch of the PNG guarantee feature. If
required employ / outsource the task to technical specialists.
[1 per point] [Max 5]

ix) ALM process to determine Investment Guarantee Charge (IGC) for the PNG funds

Determine realistic values for all key asset parameters:

 Individual bond data of existing / to be purchased bonds like face value, coupon rate,
frequency, maturity date / term etc.
 Amounts invested currently and future allocation rates (mid values of target
allocations) in to the two asset classes namely debt and equities
 Consider current yield curve and equity return’s mean, variance and correlation with
bond yields for future projections.
 MF of respective funds without IGC plus X% IGC [X = 0.00% + n (0.05%); where n = 0, 1,
2...10]

Determine realistic values for all key liability parameters:

 individual member data like age, years to retirement, past contributions etc.
 future contribution rates from employer and employee depending on current salaries
and future growth in salaries

 partial withdrawal rates relating to:

o pre-retirement cash lump sums for exigencies; or
o income drawdown post retirement
 full withdrawal rates relating to:
o transfer of assets to new scheme elsewhere on change in employment of
members;
o death benefit to nominees of pre-retired deceased members;
Page 6 of 14
IAI SA7-1222
o purchase of annuity and/or cash lump sum at retirement

We should also consider dynamic interaction (or correlations) of liabilities and assets like
increase in partial withdrawal rates during recession where asset returns are negative.

Model the key features of the asset and liability for the PNG funds’ projections in to the future.
The modelling can be done deterministically or stochastically.

In a deterministic framework, we can decide the nature and extent of the scenarios to be tested
for determining the IGC. As a base case for asset projections consider
 future bond yields that are implied by current yield curve up to certain point of time
(say for 5/10 years) in future;
 post which yields gliding (in say 5/10 years) to a long-term level yields (say 6% p.a.) and
post gliding period remain at that level; and
 a long-term equity growth rate (say 12% p.a.).

We might consider various scenarios with the impact of the following shock(s) at various points
of time in future. say after 1, 3, 5, 7, 10 …years
 increase/decrease of 100 / 200 basis points in bond yields; and / or
 30% / 40% / 50% fall in equities
 10% / 20% extra partial withdrawal rate

Then compare value of assets and liabilities at each future time for each scenario to determine
the shortfalls.

In a stochastic framework, we can make multiple (few thousands) projections, starting with the
fund's current asset distribution and assumed future allocations, to generate many possible
future economic scenarios.

The ESG (Economic Scenario Generator) should generate random bond yields and equity growth
rates consistent with forward looking means, variances and covariance. The stochastic element
of the projections would apply
 directly to the asset portfolio and investment returns, in order to assess exposure to
systematic risk.
 indirectly to liabilities in the form of dynamic partial withdrawal rates

Results are ranked in terms of a target measure - shortfall of assets relative to liabilities at a
specified future date; The assessment of the results is done in two forms
 99-Percentile: shortfall of top 1% of worst case; for e.g. in case of 10,000 scenarios 100th
worst shortfall
 95-CTE (Conditional Tail Expectation): average shortfall of the top 5% worst cases; for
e.g. in case of 10,000 scenarios average of top 500 worst shortfalls

For both approaches deterministic as well as stochastic:

Select minimum X% IGC that gives acceptable levels of shortfall keeping in mind marketability
of the product feature i.e. comparing with what competitors are charging.

Include impact of varying investment strategy (changing allocations within range specified
rather than using mid values for the funds) has on the level of shortfalls of the fund.

Include sensitivity analysis e.g. how will changes in parameter values affect the results.
[0.5 per point] [Max 12]
[50 Marks]

Page 7 of 14
 IAI SA7-1222
Solution 2:
Topics/concepts to be included in the curriculum of Retirement Advisors:
I. Fundamental Concepts in Retirement Planning
1. Need for Retirement Planning
2. Basic financial concepts associated with retirement planning
3. Features of the retirement goal
4. Advantages and importance of starting retirement savings early
5. Risk of Underestimating Retirement Goals
6. Emotional Aspects of Retirement
II. Financial Markets and Investment Products
1. Need for Making Investments to Reach Retirement Goals
2. Difference between Savings and Investments
3. Asset Class and Sub-Asset Classes
4. Features of Different Asset Classes
5. Asset Class Returns
6. Common Risks in Investments
7. Matching Investor Needs to Asset Class Features
8. Impact of Macro-Economic Factors on Asset Classes
9. Asset Allocation
10. Financial System and Investment Products
III. Retirement Planning
1. Evaluate Client’s Current Situation
2. Learn the Process of Setting the Retirement Goal
3. Investing for Accumulation
4. Post-retirement Stage
5. Risks in Distribution Stage
6. Monitor and Update the Retirement Plan
7. Behavioural Bias in Decision Making
IV. Retirement Planning Products:
1. National Pension System (NPS)
2. Working of NPS
3. Subscribing to the NPS
4. Investing in the NPS
5. Tax aspects of subscribing to the NPS
6. Minimum Assured Returns Schemes (MARS)
7. Accumulation phase Active investment fund options: Debt/Equity/Hybrid/AIFs
8. Accumulation phase Passive investment Life Cycle options:
Conservative/Moderate/Aggressive
9. Payout phase various Annuities’ options offered by ASPs (Annuity service providers)
:Life/Certain/Increasing/Joint Life/RoP (Return of Premium) or not
V. Evaluating Fund Performance and Fund Selection
1. Return on Investment
2. Different types of return calculations
3. Measures of risk in an investment
4. Benchmarks
5. Performance Evaluation
6. Matching investor’s retirement needs to product
VI. Other Investment Products
1. Mandatory Retirement Benefit Schemes
2. Voluntary Retirement Products
VII. Retirement Planning Strategies
1. Bridging Shortfall in Retirement Corpus
2. Periodic Investments
3. Retirement Income from Multiple Sources
4. Bucket Strategy: Short/Medium/Long term bucketing

Page 8 of 14
IAI SA7-1222
5. Tax Advantages in Different Stages of Retirement
6. Automating Investments
VIII. Special Situations in Retirement
1. Debt Obligations in Retirement
2. Documents for Effective Retirement Planning
IX. Regulations and Regulators
1. Country’s Regulatory System
2. Role of Regulators
3. Role of Pension Funds Regulator
4. Regulations for Retirement Advisers
5. Ethics beyond Regulations
6. Subscriber Grievance Redressal Mechanism
[0.5 per point] [Max 15]

Solution 3:
i) Large fund caps employs people that could vary significantly in their geographical locations(
remote vs populous areas, urban vs rural, mountainous vs desert etc), nature of work ( white
collared vs blue collared), occupational hazard, nature of employment ( long term vs short term)
and thus have diverge demographics( mortality and morbidity) and behaviour(early leaving).
Therefore, there exist a possibility of under/over subsidy of these risks that may not be suitable
for diverge mix of population across multi cap sponsors and sponsors may want a customized
plan as per their risk profile.
[0.5 per point] [Max 1]
 Smoothed bonus funds pool the investment and insurance risk across all participants.
 Pooled funds work best when the nature of the participating funds is similar.
 If a fund experiences very different patterns of leavers/joiners, for example, this can
result in large cross-subsidies that are inequitable.
 Such distortions could be quite material in relation to the other participants.
 All smoothed bonus funds feature some cross-generational subsidies; some sponsors
may prefer to align their funds within a single large fund than spread it across multiple
funds.
 In particular, smaller sponsors benefit from better asset diversification in pooled
vehicles
 Even a large sponsor may have higher concentration of risk in a standalone fund and
thus want to participate in smoothed fund.
[0.5 per point] [Max 2]
 A segregated plan can customize its arrangements in areas like:
◦ Investment policy; specify exclusions, special constraints (provided these do not
impair the insurer’s ability to provide the underwriting)
◦ Policy conditions; e.g. extent to which market value adjustment (due to reduced
investment return of selling bonds in high interest rate environment) are applied to
mass leavers
 It will require more effort from the sponsors / trustees who will have no fellow
participants
 But the fund will shoulder the burden of managing its funding level alone given that the
insurer is unlikely to give onerous guarantees to a single plan fund given it bears some
of these risks
 For example, a standalone fund experiencing mass retrenchments at a time when
funding levels are low would get no cross subsidy and entire risk will be borne by
sponsor and insurer
 The termination conditions are likely to be more onerous as the insurance risk will be
higher for a single fund.
 There will be greater transparency of the internal workings of the fund as experience is
directly related to sponsors fund and no discretion is left to insurer.
[0.5 per point] [Max 2]
Page 9 of 14
IAI SA7-1222
[Max 5]

ii) The fund operates on segregated basis for a sponsor plan but share demographic, behavioral
and limited investment risk in proportion to profit sharing arrangement. There is an
asymmetrical profit profile for insurer, who may only earn profits via expense charges and only
post run offs but have to contribute funds to meet solvency / liquidity requirements. Under
specific situations, it may have to contribute large amount of money if actual assets fall below
notional solvency fund. Even if the experience turns favorable in future, the profits can only be
recouped through an expense charge and post run off. Even though the reversionary bonus
depends on 10 yr G sec rate, but smoothed mechanism did permit to have formula that pays
lower bonus in years having high interest rates and low bonuses in low interest rate regime.
[0.5 per point] [Max 1]
The following situations are particularly stressful to the insurer:

 High interest rate environment followed with mass leaving/terminations/deaths: The

market value of bonds will be quite low and there may already have solvency gap. The
bonds need to be sold to payoff the accumulated benefits. This will exacerbated with
with lower future contributions (new money) coming in for investment at higher rates
in current market. Had new been higher, as is the case for matured funds with stable
employee base, the new money would have absorbed the volatility in returns.
 Persistent low rate environment – Even though the previously accumulated fund may
have increased but persistently low interest rate will start biting for new money
invested at lower rates and for some funds, the accumulated earnings may be lower
than gauranteed 3% for longer period. This will particularly be worst for matured funds
with stable employee base.
 The corpus and employees fund will accumulate at minimum rate of 3 % with solvency
deficit being funded by sponsor and insurer.
 If mass exists happen at this stage, the fund may experience liquidity issues for some of
the funds whose major chunk of contributions have been received during the low
interest rate regime.
 Funds with higher corpus prior to start of low interest rate regime and having lower
contributions in this regime ( due to declining employee base) may however be
impacted less.
 Lower expenses charged to fund: If expense charges are lower for certain funds, then
profit profile becomes even more skewed. In the event of adverse experience, the
insurer may have to continue part funding the portfolio till the run off.
 Persistent low reversionary bonus declaration may create cross subsidy between
generations of policyholders and complaint may taken up by regulator to not meeting
PRE/TCF regulations. If such recouped returns are not shared with fund as per
smoothing policy, these profits may be shared between policyholder and sponsor post
run off. Press may also try to ascribe lower reversionary benefits as collusion between
sponsors and insurer making profits (at least in run off and lower solvency
contributions) at employees expense.
 If sponsor is unable to meet solvency funding requirements or files for bankruptcy then
the insurer is at risk of undertaking full responsibility of obligations towards members.
[0.5 per point] [ Max 2]
The fund may alleviate some of this risk by :
 increasing the expense charge to maximum allowed by regulators; the sponsors and
policyholders may oppose such high charges and other competitors may be offering
plans with lower charges
 Decrease its profit share to lowest levels; this may pass on risk to sponsors but
competition may not permit such actions without losing business.
 The declared reversionary bonus may be lowered; but this creates cross subsidy
between generations of employees, some getting lower bonuses in adverse years

Page 10 of 14
IAI SA7-1222
(investment returns are retained in fund and not shared with employees) but and
others getting higher benefits.
 The insurer may allow cohorts of employees within same fund into sub fund, so that run
off for cohort does not keep moving perpetually due to additions of new employee.
However, it may reduce cohort specific diversification of risks.
 Persistent low reversionary bonus may make selling new business extremely hard due
to bad publicity and employee unions pressuring sponsors to keep away from insurers
offering low reversionary bonus.
 Allowing sponsors with similar risk profile to participate single fund. But such fund may
become prone risk of sectoral economic cycles.
 Clarify the risk assumed by insurer in the event of sponsor facing financial difficulty and
put caveats to safeguard insurers position.
 Reinsure the risk or purchase hedging instruments ( if available)
 Develop investment strategy that gives return better than 10 yr G sec rate and
guarantees returns of at least 3% in certain economic situations
[0.5 per point] [Max 2]
[Max 5]

iii) The fund operates on segregated basis for a sponsor plan but share demographic, behavioral
and limited investment risk in proportion to profit sharing arrangement. Similar to risks borne
by insurer, there is an asymmetrical profit profile for sponsor but unlike insurer, any solvency
contribution early on is recouped only post run offs but have to contribute funds to meet
solvency / liquidity positions before run offs.
Under specific situations, it may have to contribute large amount of money if actual assets fall
below notional solvency fund. Even if the experience turns favorable in future, the surplus can
only be recouped post run off. Such possibilities have been discussed in part ii.
[0.5 per point] [Max 1]
 Higher expenses charged to fund: If expenses are higher for certain funds, then it may
slowly erode the fund and may cause solvency deficit and sponsor may have to
contribute major part of it. In the event of adverse experience, the sponsor may have
to continue part funding the portfolio till the run off.
 Persistent low reversionary bonus declaration may create cross subsidy between
generations of policyholders and complaint may taken up by regulator to not meeting
PRE/TCF regulations. If such recouped returns and not shared with fund as per
smoothing policy, these profits may be shared between policyholder and sponsor post
run off. But this may be raising eyebrows from corporate governance perspective and
employee unions may oppose this and force sponsor to negotiate with insurer to
increase reversionary rates. Its necessary to have smoothing mechanism that creates
equity between various cohorts/generations of employees.
 Press may also try to ascribe lower reversionary benefits as collusion between sponsors
and insurer making profits (at least in run off and lower solvency contributions) at
employees expense.
 Bad reputation due to lower bonus rates may cause issues in attracting and hiring right
talent as post retirement benefits looks less attractive.
 If insurer is unable to meet solvency funding requirements or files for bankruptcy, the
sponsor may have to undertake full responsibility of members obligations.
[0.5 per point] [Max 2]
The sponsor may alleviate some of this risk by:
 Decreasing the expense charge or switch to insurer offering lower charge products.
 Decrease its profit share to lowest possible levels;
 Participate actively in with profit committees to declare sustainable bonus rates, a
delicate balance between low rates with higher solvency positions to reduce solvency
contributions but still giving best package
 Move the fund to insurer offering better terms to sponsors and employees
 Clarify the risk assumed by sponsor in the event of insurer facing financial difficulty.
Page 11 of 14
IAI SA7-1222
 Maintain a buffer to pay meet solvency requirement (either in cash or through debt
borrowing).
[0.5 per point] [Max 2]
[Max 5]

iv) Sponsoring employer

 Low return on smoothed bonus product in future will put them under pressure from
unions
 May have to provide funds to increase solvency position of the fund as most of the risk
lies with the employer.
 Reversionary bonuses in future years may be reduced if market does not correct but
capital requirement is still required to meet 3% gaurantee.
[0.5 per point] [Max 1.5]
The plan and its trustees
 Even though the fund’s liabilities are matched by the insurance contract, in terms of the
smoothed bonus product the plan may experience a long period of low bonuses from
now on and corrective action may be required
 May have to decrease benefits or increase contributions in future if situation does not
improve and returns make current structure unaffordable.
 The trustees do not carry any of the financial risk and risk is borne by sponsor and
insurer.
 However, as they are responsible in law for the fund’s investments they will be very
anxious to resolve the underfunded position
 In particular they will want to re-evaluate the appropriateness of the investment
strategy and the investment manager(s)
 They cannot easily move the assets to another provider; will forfeit the guarantee,
because the insurer will apply a market value adjustment as a result of the under-
funding, and so crystallise the losses.
 The plan may be in pressure if the equity drop have direct impact on operations of either
sponsor or insurer.
[0.5 per point] [Max 2.5]
Members
 None immediately as their benefits are fixed,
 But may have problems if employer cannot afford them anymore
 And if all remedies fail may see a reduction of benefits in future especially other
discretionary benefits like increases for pensions in payment
 This may impact more on active members future prospects than existing benefits in
payment and could cause changes to prevent new members joining on the current
terms.
 The members however bears the risk of consistent lower bonus payouts and inflation
higher than expected as purchasing power will go down and they will not have sufficient
funds to meet post retirement expenses.
 They also bear the risk of both insurer/ sponsor facing financial difficulty and on their
ability to pay furture contributions.
[0.5 per point] [Max 2.5]
Insurer
 Capital at risk to the extent that the low funding level cannot be repaired within the
terms of the product;
 Reputation risk to the extent that the investment policy is seen to have been
inappropriate to the objectives of the product and bonuses cannot be lowered than 3%
leading to injection of funds.
 May have to take such corrective action (e.g. remove non-vesting bonuses) as is
permitted by the contract to restore funding levels; this will not be well received
[0.5 per point] [Max 1.5]
Asset manager
Page 12 of 14
IAI SA7-1222
 Reputation: If the under performance is as a result of poor performance relative to
mandate
 the asset management agreement might be terminated
 Difficulty in securing new clients due to bad past performance
[0.5 per point] [Max 1]
Regulator
 If certain critical funding levels have been breached the regulator will require that
management implement actions to restore the balance and will monitor progress
 If the benefits paid are too low to meet post retirement benefits, than public may
criticise poor product designed by regulator.
[0.5 per point] [Max 1]
[Max 10]

v)
a) Short term alleviation
 Inject capital to rectify the underfunded position, but this will have implications on how
the money will be recouped in future.
 Change the asset manager to one with a better track record
 Change the asset allocation by making it more aggressive to make up the shortfall when
the markets recover by increasing equities.
◦ This carries a lot of risk for the insurer, and it may make the smoothed bonus
product more expensive.
◦ It also carries a lot of risk for the employer as the shortfall could increase at a time
when he can least afford it
 Invest in sectors that are likely to over perform the marker due to their cyclical nature
 Change the bonus formula to repair the funding level before declaring bonuses again or
by declaring lower bonuses, if permitted
 Stop plan for new employees, if permitted
 Reduce minimum guaranteed returns for existing / new employees
 Remove non-vesting bonuses, if any
◦ However, this step may be opposed by unions and may draw press attention thus
having impact on new business for insurer and talent acquisition for sponsors
 Introduce Market Value Adjustments for leavers, if permitted
[0.5 per point] [Max 5]
b) Long term steps
 Decrease bonus declarations (especially vesting) in future; this could be done by
arriving at a smoothing mechanics that allows for smoothing across various economic
cycle.
 Change the product when fully funded to another provider or multiple providers to
diversify investment the risk, reduce insurer specific risk
 Change the product to another type of product/asset solution; though this requires
regulatory changes
 Enter into hedging instruments and derivatives to controls excessive volatility of asset
returns
 Introduce a hedging strategy to prevent further falls in funding levels
 Change the asset allocation by making it more conservative, but this will reduce overall
return and make product less competitive
 Reduce equities, decrease volatility to provide more certainty and stability in uncertain
times. However, equity provides upside potential and hedge inflation to an extent.
Removing equity will reduce long term returns, will have benefits that may be deflated
w.r.t inflation and less useful in meeting investor needs.
 Also, this might not be within policyholder reasonable expectations
 Reduce offshore holdings, reduce currency risk, if any

Page 13 of 14
IAI SA7-1222
 Introduce other asset classes to increase diversity and reduce volatility, ie ILB’s,
Property, Hedge Funds that provides higher returns but are less correlated to equities
 Enter into alternative reinsurance that enhances balance sheet positions
 Insurer can sold the block to another insurer.
[0.5 per point] [Max 5]
[Max 10]
[35 Marks]
********************

Page 14 of 14
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

14th July 2022

Subject SA7 – Investment and Finance

Time allowed: 3 Hours 30 Minutes (14.30 - 18.00 Hours)

Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions to examinees sent along with hall ticket carefully and
follow without exception.

2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.

3. Mark allocations are shown in brackets.

IAI SA7-0722

Q. 1) You are an Investment Actuary working for a boutique investment management firm
specializing in pension de-risking in a developed country with a deep financial market. The
pension regulations in the country require a Defined Benefit (DB) style pension with
minimum guaranteed death benefits to the current employees and pensioners (and their
dependents).

As per the regulations, the pension scheme offered by the corporate (employers) is required
to be fully funded and to keep pension assets separate from those on the corporate balance
sheet; the scheme runs through an independent trust managed by the trustees. Actuarial
valuations of the pension scheme are regularly carried out and any deficit (Assets –
Liabilities) is funded by the employer on regular basis. Please note that a deficit once funded
is supposed to keep the scheme operational from returns it generates from its investments
with no future contributions required if the experience is favourable. The funds are invested
in major asset classes as per the strategic and tactical investment strategy approved by the
trustees.

For all big corporates, those have been in operation for several decades; the pension liability
is becoming too large and is a significant proportion compared to their balance sheets. The
accumulated pension liabilities across all pension schemes in the country are quite large and
investments made by pension funds now constitute a major proportion across all major class
in the country.

The economy has been reeling under a low-interest rate environment for several years now;
the rates were kept artificially low to stimulate the economy out of the 2008 credit crisis.
Further, there is a marked improvement in longevity in the general population, primarily due
to high living standards, high-quality health services made available to every citizen and
technological advancement in the health sector. The trend is expected to continue in future
as well.

The impact of low-interest rates and longevity improvement had a significant impact on
actuarial valuations and there has been a trend of increased liability (and higher deficits)
every year. Funding of this surplus has been a challenge to companies as this is eating their
profits from the core operations. Equally, trustees have been facing challenges in making
employers fund the gap as they are asking lots of challenging questions on increased
liabilities and arguing that trustees not making the right investment decision to keep the
scheme afloat without future contributions from employers.

Lately, there is a trend of closing down the scheme to new entrants and offering them a
defined contribution scheme, where contributions are made on current service and entire
investment and other risks (like longevity) are borne by the employee. The current trend is
putting pressure on both employers and trustees and both parties are working on opting for a
solution that de-risk the scheme from company’s perspective and still fulfill their obligations
to the scheme members.

You regularly meet pension fund trustees of the large corporates who want to understand the
developments in the market to enhance the returns on their investment portfolio or to help
employers de-risk the portfolio or both, to help them make strategic and investment
decisions.

i) Prepare a short note on de-risking of pension plan that can be shared with the trustees
covering brief description of, needs of key stakeholders and considerations for
implementing the solution. (10)

Page 2 of 5
IAI SA7-0722
Over the last several years, corporate bond market has developed a lot and presently it
constitutes a significant portion of investment portfolio managed by pension funds.

ii)
a) Explain the reason why the corporate bond market has developed and why it is a
choice in investment portfolio of pension funds. Please take into account the key
global financial events since 1970 affecting the bond market while formulating the
answer. (5)

b) Briefly explain the difference between the following classifications of corporate

bonds: (8)

 fixed interest and index linked;

 Investment grade and non-investment grade;
 Actual and synthetic; and
 High yield debt and Emerging market debt

You have been asked to develop a tool to explore the arbitrage opportunity in the corporate
bond market. Though the arbitrage opportunity is non-existent given the depth of the market,
you decided to build a tool to perform valuation of bonds basis fundamental factors that drive
the prices and thus assess if a given security is appropriately priced.

iii) Explain the key factors/considerations you will have to build such a tool. (5)

Benchmarking of portfolio returns has always been a key decision while entering in
investment service agreement with the trustees.

iv)
a) Explain why identifying benchmarking is a critical decision and explain key
considerations to identify the correct benchmarking strategy. (3)

b) Discuss on merits/de-merits of using notional portfolio vs index in using

benchmarking portfolio. (3)

c) Discuss key considerations in comparing and selecting suitable index from universe
of indices available in the market. (4)

One of the pension funds you are advising has considered using index as benchmark for
portfolio investment and management. The investment manager can either try replicating the
index or select sub portfolio of assets (commonly referred to as stratified sampling).

v)
a) Discuss the pros and cons of using index based investment strategy and what are
the key success factors. (4)

b) Prepare a note on index based investment strategy covering both index replication
and stratified sampling, identifying pros and cons and key considerations/challenges
in implementing index replication and stratified sampling strategy. (8)
[50]

Page 3 of 5
IAI SA7-0722
Q. 2) IRDAI issued a circular permitting investment in derivatives in 2017 for certain portfolio to
manage investment rate risk. Please answer the following questions based on the circular.

i) Why use of derivative is not permitted for Unit Linked Insurance Product (ULIP)
business? (2)

ii) List the derivative instruments permitted to manage investment rate risk. (2)

iii) Interest rate with implicit and explicit options are not permitted, explain the rationale
behind such direction. (2)

iv) List the permitted purpose for which interest rate derivatives can be used. (4)

v) Explain the Current exposure method as explained in the guidelines. (5)

vi) List the features for managing derivative investment covering the following: (5)

a. Internal Risk Management Policy & Processes

b. Exposure & Prudential Limits
[20]

Q. 3) You are working as an Investment Actuary for an investment bank in a developed country
with assets under management of over USD 250 Billions. In the past, the fund has taken
significant exposure to mortality risk by purchasing blocks of life insurance businesses.
However, the bank is under constant pressure to improve its financial performance. For
various reasons, the bank’s credit rating has also declined to BB- from AAA- two years ago.

BASEL regulations do not have a specific capital charge for insurance risk and banks were
keeping the low capital charge for insurance risk as compared to other risks. Regulators have
identified this regulatory arbitrage and proposed to have an explicit capital charge which is
supposed to be significant compared to debt/equity. This additional capital requirement may
put significant strains on the financial position of the bank.

The Chief Investment Officer (CIO) of the bank has asked you to explore ways in which
insurance risk beyond a tolerance level can be offloaded to the capital market. You decided
to put a proposal to issue mortality bonds to offload these assets.

i) Prepare a draft note on mortality bonds covering the comparison of these bonds with
corporate bonds, types of mortality bonds, investor’s needs, operational structure, and
key considerations from both bank’s and investor’s perspectives. (12)

An initial assessment of the market indicates that there is a limited appetite for mortality
bonds. However, given the low rating of the bank, there seems to be less interest in investing
in these bonds. The CIO suggested modifying the bonds and issuing bonds to the wider
capital market and suggests you to explore securitizing insurance portfolios and issuing
bonds in the market.

ii) Prepare a note on how the bank can create a securitized portfolio and issue bonds to wider
stakeholders explaining how a low-rated institution can still issue high-grade security
using securitization. (8)

Recently, a regulation has been issued by regulators that prohibits investment banks or their
subsidiaries to take direct exposure to the insurance risk. They can, however, become a party

Page 4 of 5
IAI SA7-0722
to the transaction between two insurers/reinsurers/pension funds who want to
eliminate/diversify their exposure in different insurance segments/geographies.

The CIO has made an observation that bank can increase their profits by facilitating mortality
and longevity swaps to above institutional investors by participating in such deals.

iii) Prepare a note on the structuring of these swaps identifying the needs of counterparties,
and how the margin will be earned by the bank. (3)

iv) Please explain the risk to the bank if counterparty risk is not managed properly and
provide details of how the bank will manage the counterparty risk by listing down some
key points. (3)

In order to improve the performance of the fund, the CIO has asked the Equity fund manager
to look for upcoming listed tech companies for investment. The CIO believes that the existing
tech companies have reached the peak of growth and need to look for newer tech companies:

v) What are the risks associated with the investment in a tech company and what are the
risk managing strategies? (4)
[30]

**********************

Page 5 of 5
 Institute of Actuaries of India

Subject SA7-Investment and Finance

July 2022 Examination

INDICATIVE SOLUTION

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates. The
solutions given are only indicative. It is realized that there could be other points as valid answers and
examiner have given credit for any alternative approach or interpretation which they consider to be
reasonable.
IAI SA7-0722

Solution 1:

i) Negative equity returns and low interest rates in the early 2000s, and significant falls in asset values and
historically low interest rates in the post-2008 credit crisis period, have resulted in deficits in the majority of
Defined-benefit (DB) pension plans . As a consequence, firms have been struggling to maintain their DB pension
plans as both contributions and liabilities increase. DB pension plans are now often seen as a source of financial
risk and part of inside debt. [1]

Firms are expected to face greater payment obligations in the future as pension plans mature and longevity
increases. In addition, pension obligations limit firms' financial management options and current investment
capacity, as earnings may have to be used to honour pension promises made to employees by previous
management. Hence, firms with DB pension plans are increasingly focusing on reducing pension obligations to
alleviate their impact on investment and strategic decisions, which in turn reduces the risk exposure of the
shareholders. [1]

De-risking is an important tool for effective management of an employer sponsored defined benefit pension
plan. De-risking may take several forms. Employers may choose to retain all assets and liabilities and manage
volatility by aligning a portion of the plan’s assets (generally allocated to fixed income) to a portion of the liability.
Alternatively, employers may choose to entirely eliminate the volatility and the interest rate and longevity risk
by transferring the liabilities and assets to a third party. [1]
Various DB pension de-risking strategies are available to firms. Traditional methods, such as soft and hard
freezing, aim to transfer pension obligation, and investment and longevity risks from the firm to its' employees.
[1]
Innovative strategies, such as pension buy-ins, buy-outs and longevity swaps, allow firms to transfer some
pension obligation risks to third parties (i.e. insurers) by paying a premium up-front. [1]
Hard freezing and pension buy-ins are more likely to be implemented when pension plans have longer
investment horizons, indicating higher levels of risk exposure owing to investment uncertainty. [1]
Pension plans that are exposed to more investment risk are more likely to engage in pension buy-ins. Firms that
have higher market capitalisation and capital expenditure are more likely to implement innovative de-risking
strategies. [1]
Firms that are financially constrained may go for longevity swaps. Implementing pension de-risking strategies
reduce firm risk. However, the effectiveness varies with buy-ins being the most effective in reducing risk. [1]

De-risking strategies have both advantages and disadvantages from the employer’s point of view. An analysis of
the risk/reward from transferring the risk of the obligation to another party is essential. The analysis should:

 Identify business goals and objectives of the risk transfer

 Determine if any impediments exist that restrict or limit the transfer
 Evaluate the financial risk/reward from both a cash flow and accounting perspective o Calculate the
“settlement” accounting charge or credit and determine the change in the projected benefit obligation
and pension expense
 Determine the change in cash funding requirements
 Estimate administrative and professional service fees associated with implementation
 Identify and evaluate any non-financial factors such as communication challenges Identify optimal timing
of risk transfer and impact of potential delay [2]
[Max 10]

Page 2 of 16
IAI SA7-0722

ii)
a) A number of developments have meant that bond management is becoming an increasingly important issue
for institutional investors. On the supply side, the growth of the corporate bond market has meant that bond
investors now have a much wider range of investment opportunities. On the demand side, a number of
factors have increased the interest in bond investing in the developed countries. [1]

 developments in actuarial thinking have lead to a broader acceptance that bonds are a natural asset to
match pension fund liabilities;
 Negative equity returns and low interest rates in the early 2000s , and significant falls in asset values and
historically low interest rates in the post-Great Financial Crisis (GFC) period led to reduced appetite for
equity investing;
 pension schemes are maturing, especially due to the large number of schemes that are now closed;
 legislation has increased the level of guaranteed benefits, reducing the scope for discretionary benefits
and hence the interest of trustees in trying to achieve equity out-performance;
 disclosure under IFRS of the pension mismatching volatility has caused finance directors to review their
risks and to consider increasing the pension scheme investment in bonds; and
 Insurance companies have also raised their levels of bond investment in response to the solvency worries
caused by falling equity markets. 1 mark for each point [4]
[Max 5]
b)
 Fixed interest and index linked
The main distinction between these bonds is the basis on which interest is calculated.
o The majority of bonds are issued on a fixed interest basis.
o Some governments and a small number of other issuers have issued index-linked bonds.
o Whilst these index-linked bonds are freely traded, they are much less liquid.
o An even smaller market is the corporate index-linked one. The main reason for this is that
o very few issuers enjoy incoming cash flows that are known in real terms (utility companies being
notable exceptions in the UK, e.g. gas prices being set using an “RPI-X” formula).
o It is also true that accounting for fixed interest debt is easier than accounting for index-linked debt.
o Currently, though, most index-linked corporate bonds trade at lower spreads than conventional
bonds, although there are a few examples where illiquidity has widened the spread.
o Given that inflation has fallen from historic levels, the question of what happens to indexlinked
bonds in times of deflation becomes more important. Thus it is possible for coupon rates to fall or
the final redemption payment to be lower than the face value in nominal terms
1/2 mark for each point [2]
 Investment grade and non-investment grade

o The most obvious form of credit risk is the risk that the borrower defaults on one or more
payments. Generally government bonds are deemed to be very secure with little or almost no risk
of default (the same cannot be said for the governments of less stable countries).
o A further category of credit risk is the risk that the issuer’s credit rating is downgraded by the rating
agencies.
o If this is unanticipated the credit spread associated with the issue will usually increase and result in
a decline in the price of the bond concerned.
o Although there are a number of agencies that provide credit ratings for bonds, the two most

Page 3 of 16
IAI SA7-0722

o widely used are Moody’s and Standard & Poor’s. Bonds that are rated (and not in default) are
graded from AAA to CCC by Standard and Poor’s, and Aaa to C by Moody’s.
o Anything with a Standard and Poor’s rating of BBB or above (Baa for Moody’s) is classed
o as investment grade; anything with a rating lower than this is classed as high yield.
o Bonds that are given different ratings by different agencies are classed as having a split rating.
1/2 mark for each point [2]
 Actual and synthetic

o Actual bonds are directly issued by government and corporates and have typical features like
coupon, maturity dates and assets backing the bonds that are specified in the bond document.
o Synthetic bonds are other types of bonds that are repacked from fixed or contingent cash-flow
streams into fixed interest security.
o E.g. CBO’S are essentially portfolios of bonds repackaged as a single fixed interest security.
o MBSs are instruments issued by housing loan companies, where the repayment on the bonds is
contingent on the repayment of housing loans originated by the loan companies – mortgages are
effectively packaged together and issued on the open market as debt.
o Using some specific swaps, it is possible to create synthetic bonds – for example buying a
corporate bond and then swapping the coupons for inflation linked payments in effect creates a
corporate bond with inflation linked cash flows.
o Alternatively you can create a synthetic sterling bond from a US or a euro-denominated bond by
using currency swaps 1/2 mark for each point [2]

 High yield debt and Emerging market debt

o High Yield bonds (and indices) include bonds with ratings below investment grade, which
therefore means a credit rating of BB+ / Ba1 or below.
o High Yield bonds are much less liquid than investment grade bonds, meaning that bond pricing
can be less accurate, and also adjustments are often made to the spreads.
o The main high yield index providers are MSCI and Credit Suisse and JP Morgan.
o Emerging Markets are usually defined as countries with lower than average per capita income.
o For example, JP Morgan use the World Bank-defined “middle income” per capita upper level (in
US$) as one of their criteria.
o Also, having had their debt restructured may allow a country to be eligible for entry into an
Emerging Market Index which help in providing liquidity and price stability to these bonds.
o Emerging Market bonds can be in local currency markets, although these usually consist of
shorter maturities as emerging bond markets are often quite small in their domestic currency
and do not usually have a wide range of maturities.
1/2 mark for each point [2]
[Max 8]
iii) The majority of the pricing models used by portfolio managers are complex multidimensional surface models
that consider the outstanding term, yield, credit rating, default probability, expected recovery values and sector
of an issue. [1]
Portfolio managers attempt to derive their own estimate of “fair-value” for a bond based on their views on the
features of the issue. Their models then attempt to identify any anomalies between their assessed “fairvalue”
and the price the bond is trading at in the market, as well as any anomalies between the issue and related swaps
or forward contracts. [1]

Page 4 of 16
IAI SA7-0722

 Number of bonds ; In comparison with equities, there are a vast number of bonds in issue and one corporate
 Group may have in issue a number of different securities with different credit ratings, seniority and issued by
different entities within the group.
 Market size and liquidity; These vary between issues. For example in the treasury market the most recently
 issued securities, referred to as “on-the-run”, tend to trade far more actively than older issues or those that
are “off-the run”
 Market makers risks; The amount of risk that a market maker is required to take to make a book in a particular
issue will be reflected in the bid offer spreads that they quote, particularly in illiquid issues.
 Factors affecting price: There are a large number of factors affecting the price of an issue, one of which is
often the fact that an issuer has several bonds that can be purchased. These factors lead to matrix pricing and
to the multi-dimensional models referred to above.
 Counter party trading: The lack of pricing transparency caused by counter party trading (as opposed to
exchange trading for equities) creates an informational imbalance. At any one time there is no one agreed
market price for a corporate bond even though bond pricing is increasingly more widely available thanks to
electronic trading.
 Additional features: Features, such as interest rate caps and floors and credit step-ups, can be difficult to
evaluate.
 Supply and demand: Supply and demand vary and are not always predictable. Possible discontinuities are
very difficult to assess.
[Max 5]

iv)
a) A benchmark is a standard or measure that can be used to analyze the allocation, risk, and return of a given
portfolio.
 Risk levels usually vary across equity, fixed income, and savings investments.
 As a rule, most investors with longer time horizons are willing to invest more heavily in higher-risk
investments. Shorter time horizons or a higher need for liquidity–or ability to convert to cash–will lead to
lower risk investments in fixed income and savings products.
 With these allocations as a guide, investors can also use indexes and risk metrics to monitor their portfolios
within the macro investing environment.
 Markets can gradually shift their levels of risk depending on various factors. Economic cycles and monetary
policies can be leading variables affecting risk levels.
 Active investors who use appropriate benchmarking analysis techniques can often more readily capitalize
on investment opportunities as they evolve.
 Comparing the performance and risk of various benchmarks across an entire portfolio or specifically to
investment fund mandates can also be important for ensuring optimal investing.
 Portfolio managers will generally choose a benchmark that is aligned with their investing universe. Active
managers seek to outperform their benchmarks, meaning they look to create a return beyond the return of
the benchmark.
 And lastly, benchmarks can have the effect of modifying the behavior of fund managers else they would
have deviated from investment strategy in search of Alpha by taking on more risk than expected.
[Max 3]

b) Notional Portfolio

Page 5 of 16
IAI SA7-0722

- The notional portfolio for a pension scheme is that portfolio of bonds & equities which most closely matches
the liability characteristics
- Under certain economic and demographic assumptions, the cash flow pattern for larger pension schemes
can be predicted with a reasonable degree of accuracy
- provides the appropriate benchmark against which to judge all other available investment strategies
- is easy to manage and less time consuming if liabilities are predictable/less volatile to economic and
demographic assumptions

Disadvantages;
- Needs re-balancing of portfolio of economic / demographic assumptions have changed
- no surety of nonperformance of actively managed funds
- may require frequent re-balancing
- more time consuming as trustees have to spend time on re-balancing the notional mix due to change in
liability profile
- For many pension schemes, a substantial (and growing) proportion of the liabilities increases in line with
Limited Price Indexation (LPI) in payment, but there is limited availability of LPI assets
1/4 mark for each point [1.5]
Index Portfolio

 An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a
financial market index.
 Index funds have lower expenses and fees than actively managed funds.
 Index funds follow a passive investment strategy.
 Index funds seek to match the risk and return of the market based on the theory that in the long term,
the market will outperform any single investment.
 By having the suitable sub index, can mimic any type of liability.
 Can be time consuming in construction but easy to manage thereafter 1/4 mark for each point [1.5]
[Max 3]

c)
 Corporate bond and government bond indices have not changed fundamentally for 15 years.
 A recent phenomenon is using indices based on credit default swaps, which are rapidly overtaking
corporate bonds as the most liquid way to trade corporate credit.
 The leading product in this area is TRAC-X from JP Morgan and Morgan Stanley, which is a family of
indices across regions.
 The advantage of these products is that they are actually tradable and hence truly reflect the market.
 Already many other banks are trading these products and their predecessors
1/2 mark for each point [2]

The criteria necessary for the construction of a good index include the following:
 Transparent: There should be clear rules on methodology, index changes and eligibility criteria.
 From an experienced provider: The provider should have suitable knowledge of the market, with a
commitment to calculating and supporting their index.
 Replicable: Detailed data of the index, including its constituents, construction and performance, must
 be widely available to market participants.

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 Representative: The index should be a fair representation of the major characteristics of the market
sectors included. Diversification is also relevant given the asymmetry in bond returns.
 Investible: Bonds within the index should meet basic liquidity criteria and be available for investment
by a wide range of investors.
 Flexible: Investors can construct customised strategies using sub-indices.
 Reflective of investor needs: The index should provide a fair basis for peer group comparison.
 Consistent: The index rules should remain stable Bonds will be removed or added in line with index
1/4 mark for each point [2]
[Max 4]

v)
a) The objective of indexed fixed income funds is to produce returns that mirror those of a specified
benchmark index;
- Portfolio will achieve virtually the same return as the broad market
- Outperforms the majority of actively managed funds
- Low turnover in indexed funds together with lower management fees leave more of the money to
be invested
- Broad diversification: Index funds tend to hold a great breadth of securities, minimising non-
systematic, or issuer specific risk to a portfolio
- Less time-consuming: Trustees will generally spend less time monitoring a passive manager
- Rule based investment decision-making process: Indexed portfolios are managed according to an
objective process based on quantitative models and strict rules to track an index’s performance
1/4 mark for each point [1]
Arguments against passive management include;
- Anomalies in index construction
- Inefficiencies in corporate bond markets
- The corporate bond market is extremely inefficient compared to equity markets
- Sampling challenges; The problems identified above have led passive managers down the
sampling route, attempting to replicate the index with a “mini-index” containing far fewer stocks
1/4 mark for each point [1]
Key success factors:

- A thorough understanding of the market environment, including issuance patterns, maturity structure
and taxation issues, is needed.
- The manager should have detailed knowledge of the benchmark indices, including index rules, and the
ability to anticipate, understand and reflect within a portfolio all index changes.
- It is essential to have a portfolio construction methodology that is rigorous, objective, scientific and
robust. Efficient trading
- Efficient trading practices that limit transaction costs help to keep costs down and aid tracking.
- There should be daily monitoring, performance attribution and analysis in place. This should feed
through to a joint focus on minimizing tracking error while minimizing costs
1/2 mark for each point [2]
[Max 4]

b) Full replication

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IAI SA7-0722

 Full replication is a process whereby the fund manager buys all the bonds that make up an index
 The strategy is simple to execute: Hold every bond in the index in the same weight as the index
 A full replication strategy is advantageous only when you’re dealing with indexes that can be easily
replicated.
 It provides broad exposure to the index, ensuring better diversification and lower turnover costs.
 On the flip side, these advantages disappear when dealing with complex or illiquid markets, such as
emerging market bonds
 Replication is the preferred index portfolio construction method for indices comprised of a small
number of bonds and where portfolio turnover is low.
 The cost of buying all the stocks in such an index is minimal, and the tracking error only creeps in when
there are index changes – this is where experienced portfolio management and trading teams are
important.
1/2 mark for each point [2]

Stratified sampling
 Sometimes, it’s not possible to buy all the components of a leading market index. That’s where
stratified sampling technique comes in handy.
 As the name implies, a stratified sampling strategy invests in a ‘sample’ of holdings from the underlying
index. The combination of ‘sampling’ and ‘optimization’ means the portfolio gains exposure to certain
segments of the index to provide an acceptable level of risk versus reward.
 Sampling and optimization are beneficial because they provide the most representative sample of the
index based on key metrics like exposure, risk, and correlation. But unlike the full replication strategy,
sampling and optimization could leave you under-exposed to the index you are trying to track, which
could lead to subpar returns
 The rebalancing may be required if characteristics of bond in sub group changes – this is where
experienced portfolio management and trading teams are important.
1/2 mark for each point [2]

The index is broken down into sub-groups or cells sharing similar characteristics.
 index portfolio construction then buys small number of bonds within each of these sub groups and tries
to remain within limits set for each sub-group
 The cost of buying all the bonds in such an index may be larger as very few bonds will fall within each
sub group and have trading/volume and market liquidity issues. 1/2 mark for each point [1]

Cells/sub groups are constructed according to the following characteristics:

 duration;
 sector/industry;
 credit rating; and
 liquidity. [0.5]

The following average statistics are calculated for each cell:

 weight in the index;
 average duration;
 average yield;
 average option adjusted spread; and
 average convexity. [0.5]

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 IAI SA7-0722

The sample is stress tested to see if it will react in the same way as the cell from which it is taken. Each sample
is stress tested against changes in the yield curve such as:
- Parallel shift (a change in yield of the same amount at all durations);
- Butterfly shift (a change in yield in one direction at a medium duration and in the opposite direction for long
and short durations); and
- twist (a change in the difference between yields at long and short durations). [1]

When sampling bonds from each cell, care needs to be taken to diversify across issuers, and to keep issuer
weights in the sampled portfolio in line with index weights. Issuer diversification in a portfolio minimizes
tracking error caused by event risk. [1]
[Max 8]
[50 Marks]
Solution 2:

i) Under current ULIP regulations, ULIPs do not have minimum guarantee returns and policyholders have to
bear all of the risk.
- using derivatives, the downside risk could have been managed but it may violate other regulatory
requirements related to cost particularly maximum Fund management charges and maximum reduction in
yield gaurantee
- The equity derivatives market is not fully evolved and options are available for short durations and have
significantly high premiums for term higher than earliest option maturity date.
- Thus they seems to be not suitable for long term hedging without undue cost towards buying options on
regular basis.
- Similarly, the swaps may have been used to hedge interest rate risk but given the liquidity profile of ULIP, it
will be very difficult and costly to manage the swap hedging portfolio and may have higher cost to offer such
products to the customers. 1/2 mark for each point
[Max 2]

ii) Insurers can enter Forward Rate Agreements (FRAs), Interest Rate Swaps (IRS), Exchange Traded Interest Rate
Futures (IRF) to “hedge” Interest Rate risk on forecasted transactions, for Life, Pension & General Annuity
Business and General Insurance Business. Interest Rate Derivatives are not permitted for ULIP Business.
[2]
Participants can undertake different types of plain vanilla FRAs/IRS. IRS having explicit/implicit options features
are prohibited. [0.5]
Insurers are allowed only as “Users” (protection buyers) of Credit default swaps(CDS). [0.5]
The CDS are permitted as a “hedge” to manage the Credit Risk covering the credit event and not for managing
spread risk. The category of the investment will not change pursuant to buying CDS on such underlying. [1]
[Max 2]
iii) Interest rate derivatives with implicit and explicit options are not permitted because;
- they have higher costs than plain vanilla instruments
- being sold in low volumes means trading/liquidity issues
- these derivatives may be difficult to wind up/ closed as option value may become significant in some
scenarios.
- accordingly, will be difficult to rebalance the portfolio with relative ease as possible with vanilla swaps.

Page 9 of 16
IAI SA7-0722

1/2 mark for each point

[Max 2]
iv) Exposure to Interest Rate Derivatives
Exposure to Interest Rate Derivatives are permitted for hedging for forecasted transactions mentioned below:

i. Reinvestment of maturity proceeds of existing fixed income investments

ii. Investment of interest income receivable;
iii. Expected policy premium income receivable on the Insurance Contracts which are already underwritten [2]

The overriding principle of any use of the above listed derivatives is that they must be used only for hedging to
reduce interest rate risk. The Insurer should have a system to clearly track the Interest rate risk. [1]

To consider expected policy premium income for hedging, Insurers shall document and justify persistency
assumptions as part of the hedge program development process approved by the management. [1]
[Max 4]
v) Regulatory Exposure and Prudential Limits for measuring exposure
a) Counter parties shall necessarily be Commercial Banks and Primary Dealers (PDs) as permitted by RBI for FRAs
and IRS. [0.5]
b) Insurers dealing in FRAs and IRS have to arrive at the credit equivalent amount for the purposes of reckoning
exposure to counter-party. [0.5]

For the purpose of exposure norms, Insurance companies shall compute their credit exposures, arising on
account of Interest rate derivative transactions using the Current Exposure Method (CEM) as detailed below:

 The Credit Equivalent Amount of a market related off-balance sheet transaction calculated using the current
exposure method is the sum of current credit exposure and potential future credit exposure of these
contracts. [1]
 Current credit exposure is defined as the sum of the gross positive mark-to-market value of these contracts.
[1]
 The Current Exposure Method requires periodical (at agreed periodicity) calculation of the current credit
exposure by marking these contracts to market, thus capturing the current credit exposure. [1]
 Potential future credit exposure is determined by multiplying the notional principal amount of each of these
contracts irrespective of whether the contract has a zero, positive or negative mark-to-market value by the
relevant add-on factor indicated below according to the nature and residual maturity of the instrument. [1]
[Max 5]
vi) Internal Risk Management Policy & Processes, Exposure & Prudential Limits
Each participant should, before taking exposure to Interest Rate derivatives, frame detailed pre-approved risk
management policy by the Board of Insurer, which shall cover the following minimum: [1]
 Insurer’s overall appetite for taking risk and ensure that it is consistent with its strategic objectives, capital
strength etc.
 Define the approved derivatives products and the authorized derivatives activities.
 provide for sufficient staff resources and other resources to enable the approved derivatives activities to be
conducted in a prudent manner;
 ensure appropriate structure and staffing for the key risk control functions;

Page 10 of 16
IAI SA7-0722

 establish management responsibilities;

 identify the various types of risk faced by the Insurer and establish a clear and comprehensive set of limits
to control these
 establish risk measurement methodologies which are consistent with the nature and scale of the derivatives
activities;
 require stress testing of risk positions;
 detail the type and frequency of reports which are to be made to the board (or committees of the board);
 Applicable VAR limits.
 Circumstances for termination and closure of the contract.
 accounting treatment of the proposed derivatives in the company, and
 Solvency / capital impact due to the use of derivatives. 1/2 mark for each point [4]
[Max 5]
[20 Marks]
Solution 3:

i) Mortality bonds are designed to offload mortality risk beyond a tolerance level from an underlying block of
life insurance policies. These bonds protect issuers from actual mortality claims pay-out being higher than a
defined limit. [0.5]

If an “event” does not occur, investors receive their principal back at the end of the term. If the event does
occur, the investors will lose part or all of their investment, which is paid to the insurance company to offset
some or all of its loss. The bond issuer must set the underlying mortality used, the trigger point for an event,
the grading from a partial payment to a total loss of investment and the rate of return paid to investors. [0.5]

The principal repayment of the bond on maturity is subject to the level of mortality being lower or higher
than a defined limit.

Investors receive coupons at a predefined frequency and at predefined levels e.g. 3 months LIBOR plus 110
basis points. [0.5]

However, the principal is unprotected and depends on what happens to a specifically constructed index of
mortality rates.

The principal is repayable in full if the mortality index does not exceed a defined level e.g. 1.2 times the base
level during any of the years of the tenure of the bond.

The principal is reduced by X% for every Y% increase in the mortality index above the threshold of 1.2, and is
completely exhausted if the index exceeds say 1.6 times the base level. [1]

The mortality index can be for a country or multiple countries or for insured lives or based on population
mortality. [0.5]
Total [3]
There are numerous differences between mortality bonds and corporate bonds. The key differences are as
below:

1. Under mortality bonds the principal payment is contingent on the level of mortality at the maturity of
the bond. Such contingent principal payment does not exist in the case of corporate bonds.

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IAI SA7-0722

2. All other things being similar, mortality bonds offer higher yields compared to corporate bonds given
that investors take the additional risk of principal amount repayment being continent on the levels of
the mortality index.
3. Mortality bonds are a type of securitized instrument and corporate bonds are not.
4. The motive of the mortality bond issuer is to protect from excessive levels of mortality and the motive
of corporate bond issuers is to raise additional capital.
5. Mortality bonds market is much smaller as compared to corporate bonds, and the corporate bonds
market is much more liquid. Total [2]

The common needs of investors in mortality bonds are as below:

 A pension fund invests in mortality bonds to protect from the longevity risk i.e. should the levels of
mortality be lower than the pre-defined index the pension house earns higher yields from the mortality
bonds thus protecting it from the longevity risk
 A fund house could purchase these bonds to enhance the yields at a lower risk and the investment is low
beta i.e. low correlation with standard financial market risk factors.

The common needs of the issuers of mortality bonds are as below:

 The bond helps the issuer to unload some of the extreme mortality risks that it faces.
 The issuer of the bond (bank) is mindful of its credit rating and desires to reassure rating agencies about
its mortality risk management by offloading extreme mortality risk.
 Further, by issuing the bond itself, issuers are not dependent on the creditworthiness of other
counterparties (e.g. reinsurers) should an extreme mortality event occur.
 Thus, the bond gives the issuer some protection against extreme mortality risk, without requiring that
the company acquires any credit risk exposure in the process.
 Another approach is to purchase a simple high-limit stop-loss cover. The drawbacks to this tool are it is
relatively expensive and it usually has exclusions (such as terrorism, nuclear, biological). Mortality bonds
has no exclusions and thus offer greater protection to issuers. Total [3]

Operational structure: The operation structure of a mortality bond is similar to any other securitized bond.
Typically involving three parties – Originator (Issuer), Special Purpose Vehicle (SPV) and investors (bondholders).

[2]

There are many possible types of mortality bonds, but they fall under two broad categories. The first is ‘principal-
at-risk’ mortality bonds. These are bonds in which the investor risks losing all or part of the principal if the
relevant mortality event occurs. The second is the ‘coupon-based’ mortality bond. These are bonds in which the

Page 12 of 16
 IAI SA7-0722

coupon payment is mortality-dependent. [2]

[Max 12]

ii) The block of life insurance business with the bank is an illiquid asset that can be converted into securities that
can be bought and sold in the financial market. [0.5]

Individual life insurance policies are illiquid and individual life insurance policies can be pooled together to form
an income stream. The marketable securities i.e. bonds can be created from this stream of income. By
securitizing the block of policies, the bank can release the embedded value. [0.5]

The main purposes of this type of deal are to release capital to reinvest into core businesses, to prove to
regulators and rating agencies that the present value of future profit from a block of business is a liquid asset
and to increase the return on equity for the underlying business. [0.5]

Like other securitized assets, the bank will need to create a special purpose vehicle (SPV) to issue marketable
securities made from the insurance block. [0.5]

Securitizing this block the bank can de-risk itself from the insurance block and investors can get access to the
profits emerging from this block. Investors would expect higher returns from the bonds given that the risk of
the underlying blocks is transferred to the bondholders. [1]

The bank can engage SPV in two ways either by transferring the entire insurance portfolio subject to regulatory
requirements or transferring profits only emerging from the block. If the bank is transferring an entire portfolio,
then the SPV will have to maintain and serve the entire block of policies and incase of transfer of the underlying
income the portfolio and policy servicing will still be with the bank, and income generated will be transferred
to SPV. The SPV can create a variety of bonds from the insurance portfolio: [1]

High coupon yielding bonds:

The bond is an annuity (or amortizing) bond with floating coupon payments. The coupon rates are dependent
upon the profitability of the underlying insurance block. SPV will declare annual coupon rates based on the
profits emerging from this block. The coupon rate will depend upon the performance of the underlying block.
The performance of the underlying block depends upon many parameters such as investment returns on the
reserves, levels of mortality claims, expenses, policy lapses, etc. [1]

The coupon rate will be higher should the experience from all these parameters is favorable e.g. much lower
levels of mortality than assumed into reserves or above average returns from the underlying reserves. [0.5]

The proceeds from the bonds issued will be transferred to the bank and on the maturity of the bonds bank will
transfer the proceeds back to the SPV to make the payment to bondholders.

Zero coupon bonds: where the yearly profits (income stream) emerging from the block of business are
accumulated over the tenure of the bond. The accumulated income stream and principal amount are paid back
to investors on the maturity of the bond. [0.5]

A low-rated institution can still issue high-rated bonds:

The assets being securitized permanently shift from the originator’s balance sheet to that of the SPV. The SPV
is set up such that it is bankruptcy-remote, meaning that the underlying asset pool is held separately from the
other assets of the originator (bank). In effect, the SPV and its assets are protected from insolvency or

Page 13 of 16
 IAI SA7-0722

bankruptcy of the originator. In other words, the originator’s credit rating and financial status become almost
irrelevant to the bondholders when assets are held within an SPV framework. [1]

To further boost the credit quality of the SPV, the process of securitization often involves credit
enhancements. The term refers to methods used to improve the credit profile of the SPV to make the
securitized assets on sale more marketable. One form of credit enhancement occurs in the form of a third-party
guarantee of performance. Notes issued by an SPV that has obtained a third-party guarantee are often rated
at investment grade and up to AAA grade. In this way, the low-rated institution can still issue high-grade security
using securitization. [1]
[Max 8]

iii) A mortality swap is an agreement to exchange one or more cash flows in the future based on the outcome of
at least one (random) survivor or mortality index. [0.5]

Mortality swaps bear considerable similarity to reinsurance contracts. Both often involve ‘swaps’ of anticipated
for actual payments (or claims), and both might be used for similar purposes. However, there are major
differences between them. Most especially, mortality swaps are not insurance contracts in the legal sense of
the term and therefore not affected by some of the distinctive legal features of insurance contracts (e.g.
indemnity, insurable interest, etc.). [0.5]

Mortality swaps have certain advantages over mortality/longevity bonds. They can be arranged at a lower
transaction cost than a bond issue and are more easily cancelled. They are more flexible and they can be tailor-
made to suit diverse circumstances. They do not require the existence of a liquid market, just the willingness
of counterparties to exploit their comparative advantages or trade views on the development of mortality over
time. [1]

This enables pension plans to partially or wholly hedge their longevity risk without having to purchase annuities
or hedge insurance companies from extreme mortality events such as a pandemic. The instruments are
structured in a similar way to interest rate swaps. For example, the pension plan receives a series of variable
payments that reflect ‘actual’ mortality patterns (often called the floating leg), in exchange for paying a series
of fixed payments to the counter-party (often called the fixed leg). This arrangement is designed to provide
certainty to the pension plan regarding the mortality rates of the covered population. [1]

In plain vanilla mortality swaps in which the preset rate leg is linked to a published mortality projection, and
the floating leg is linked to the counterparty’s realized mortality. [0.5]

Bearing in mind that swap payments would be conditioned on particular time periods and reference
populations, firms could use such swaps to manage their exposures across both reference populations and
across the ‘mortality term structure’. For example, firms in different countries could enter into such swaps to
diversify their longevity risk exposures; alternatively, firms might enter into such swaps to alter their ‘mortality
term’ risk exposures. [0.5]

The bank can earn from being a party to the swap arrangement or being a deal maker earning a commission by
bringing parties together. [0.5]
[Max 3]

iv) Counterparty risk is referred to the risk of potential expected losses that would arise for the bank on account
of default on or before the maturity of the derivative contract by another counterparty to such a derivative
contract. It is prevalent in all types of transactions when they are undertaken through over-the-counter (OTC).

Page 14 of 16
 IAI SA7-0722

[0.5]

Each security involves a number of different counterparties, and the success of the contract relies on
establishing sufficient confidence that contracted cash flows will actually be paid. In some cases, such as
longevity bonds, these cash flows are as far as 25 years into the future. [0.5]

The primary role of longevity bonds and other mortality-linked securities is to give holders the opportunity to
hedge their systematic longevity risks. These investors do not seek exposure to alternative market risks or to
additional credit risks. Where any of the key participants carry a risk of default, we therefore also have to
consider structures to mitigate this risk. These can make a difference to the price which will be paid, and even
to the willingness of investors to participate in the first place [0.5]

Credit risk might be mitigated using a credit insurance arrangement, such as a financial guaranty or surety bond:
a firm might purchase such insurance to protect itself in the event that its counterparty defaults; or a firm might
make itself a more attractive counterparty by purchasing insurance for its counterparty to protect the latter
from loss in the event of its own default. However, such insurance can be expensive. [0.5]

Credit risk might be mitigated using credit derivatives (e.g. credit default swaps) which promise payments if
specified credit events occur (e.g. such as the default or downgrading of a counterparty). However, the
reference credit events need to be chosen carefully if they are to avoid serious basis risk problems, and, as with
credit insurance, credit derivatives can be expensive. [0.5]

Counterparty credit exposures can also be managed using standard credit enhancement methods such as
collateral agreements, collateralization with marking to market (so that positions are periodically marked to
market, and collateral reassessed accordingly in line with pre-agreed formulae), recouping (in which cash is
exchanged when exposures hit pre-agreed limits and payment schedules are re-set to bring the swap value
back to zero), credit triggers (in which a counterparty suffering a specified credit downgrade is obliged to close
out its swap position and to settle its outstanding debts), and mutual termination options (giving either party
options to terminate a swap agreement). [0.5]

Each of these methods has proven to be useful in helping firms manage the counterparty credit risks of existing
types of the swap, and they are especially useful when the swaps are very-long dated ones as would typically
be the case with mortality swaps.

Another commonly used way of mitigating credit risk is through a special purpose vehicle (SPV)
[Max 3]

v) Investments in technology companies seek long-term growth of capital. The technology companies that the
CIO believes can bring long-term capital growth are those driving technological innovation or benefitting from
the enablement of technology. [0.5]

Key risks with investment in tech companies are as below:

Valuations: The tech companies carry high valuations, measured in the form of a high price-to-earnings ratio.
The valuation for many emerging tech companies is high even though the earnings are in red territory. High
valuations are formed based on tech companies’ potential to grow and being cost-effective to produce high
positive earnings. Should the company fail to achieve targets the value of such company crashes leading to a
massive loss on investments. [0.5]

Crowding: Investors have crowded into a handful of tech leaders. Crowding is a risk because it may mean that

Page 15 of 16
IAI SA7-0722

even a relatively minor negative news event for a tech leader could trigger a sell-off and a sharper-than-
expected downdraft for the broader market. [0.5]

New Tech Companies are new and unproven: Tech companies are vulnerable because of their relative newness.
Most new tech companies haven’t been around long enough to prove themselves to investors, making it tough
for investors to predict how they’ll fare (or even whether they’ll pull through) during a market slump. [0.5]

Inflation: the current rising level of inflation has led to a rise in the expected interest rate. This higher expected
interest rate has a negative effect on stocks that are sensitive to future growth expectations, such as stocks in
tech companies. Higher interest rates impact the spending ability of consumers and that can hit hard the
projected growth of the tech companies. Most smaller companies have an aggressive plan for growth, but
actually meeting those targets is another question altogether, especially in a time of rising interest rates which
can severely cause valuation issues. [0.5]

Risk management in the case of tech companies:

Diversification: The best way to manage risks is to run a diversified portfolio so that the few winners can offset
the many losers.” That’s a labor-intensive process and difficult for the average investor to manage. [0.25]

Consider reducing tech exposure by adding to other sectors, such as financials, industrials or materials. [0.25]

Index: It is easier to see the development of a theme than to pick a single winning company. An index approach
to investing in tech is more likely to succeed than buying one or two stocks. [0.25]

Investing in tech companies with multi-products. [0.25]

Investing in tech companies where management must have and able to demonstrate a clear path to
profitability. [0.25]

Being informed and changing investment focus e.g. many of the biggest ideas in technology over the past
decade have centered on how people communicate, consume, transact and travel. Over the next decade,
however, it could be the most profound innovations — and investment opportunities — could be on factory
floors, in operating rooms, at mining sites, and energy facilities. To change the investment direction with the
expected change in the sector. [0.5]

Investment can focus on market leaders who typically are more likely to be profitable, generate stronger cash
flows, have “higher barriers to entry” in their respective spaces, and have a better chance to withstand volatility
or a market correction. Those companies also have the ability to “buy out” smaller companies entering the
domain of the market leaders or that have complementary technology platforms. [0.5]

[Max 4]
[30 Marks]
**********************

Page 16 of 16
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

9th March 2022

Subject SA7 – Investment and Finance

Time allowed: 3 Hours 30 Minutes (14.30 - 18.00 Hours)

Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions to examinees sent along with hall ticket carefully and
follow without exception.

2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.

3. Mark allocations are shown in brackets.

IAI SA7-0322
Q. 1) You are a marketing Actuary in a large global fund. A portfolio manager in the fund wishes
to launch a US private debt fund in the global market for institutional client and has asked
you to prepare marketing material for potential institutional clients.

i) Describe the relative advantages of investing in public debt versus private debt for
institutional clients. (7)

The US portfolio manager decided to raise capital over a period of 12 to 18 months which
then will be invested in Private Debt issued by US companies only. The term of the fund
will be 10 years post closure of New Fund Offering (NFO). The intended portfolio size is
expected to be USD 200 Million with portfolio manager committing a seed capital of USD
10 Million. The fund will distribute first 6% of annual returns to investors and rest of the
returns will be distributed in the proportion of 20/80 (portfolio manager/investor). The Fund
is expected to charge a flat fee of 1.5%.

The proposal is presented to risk committee and chairman of risk committee had expressed
some reservation over the design. He asked you to identify the potential risk as well as any
enhancements that could be made to make the product more appealing.

ii)
a) Describe the main risks for an investor and, where possible, suggest product
enhancements to mitigate these risks. (7)

b) Describe the main risks for the firm in launching this product and if possible,
suggest product enhancements to mitigate these risks. (8)

A regulator in your country requires showing Effective Annual Charge (EAC) of the fund
over the term of the fund and asked you to disclose the same in the NFO. The finance
provided you details of other costs in addition to those described above:

 Administration cost - 0.5%

 Advice fee - 1.5% in the first year, 0.5% thereafter
 Other - 3%

*please note all costs exclude VAT.

iii) Calculate the EAC assuming that full capacity of the fund is sold and an annualised
return of 20% is achieved over the 10 year period. (3)

Regulator has organised a webinar for effective interaction between fund managers and
institutional investors. One of the agenda of the webinar is to present economic conditions:

iv)
a) Describe the current state of Indian economy highlighting broad economic
parameters and recent policy decisions. (5)

b) Provide an overview of the Indian and US capital markets with particular

reference to the recent developments in these markets. (5)

The portfolio manager is considering implementing an alternative fee charging structure

consisting of a 2% pa flat fee plus a performance fee of 20% of any outperformance above
WPI index change + 5%. Performance fees are measured over rolling 1-year period.

Page 2 of 3
IAI SA7-0322
v)
a) Discuss the appropriateness of this proposed fee and the relative merits of
performance fees compared with flat fees in the context of this fund. (5)

b) Recommend how this fee structure could be amended to be more attractive to

investors and the portfolio manager. (5)
[45]

Q. 2) A large Government-owned life insurance company is planning an Initial public offering

(IPO). The company had decided to offer shares to the existing policyholders of the life
insurance company at a discount of 5% on the issue price. This has led to an overwhelming
response from the existing policyholders and many of them would be an amateur first time
investors as well.

i) Discuss how a professional and amateur investor will analyse this investment
differently. Discuss the behavioural aspects of the difference in the approach of
investment analysis. (10)

You are the Chief Research Officer of an investment advisory firm, an amateur high net
worth Investor aged 65 years has approached you for your views on this investment.

ii) What are the main biases in conducting research? Please illustrate with examples. (7)

The investor would also need your expertise to understand whether he should invest directly
in the company or go for a mutual fund scheme which invests more than 70% of his fund
in the shares of this company. The remaining 30% is in other private life insurance
companies.

iii) Please advise with focus on his risk appetite and relative advantages and disadvantages
of investing in the equity and a life insurance fund. (5)

iv) What are lifecycle investments and what would be your advice to the client with regard
to this. (3)

v) Discuss how investment performance are measured and analysed. (10)

[35]

Q. 3) In the Union Budget announced recently, the Finance Minister announced the introduction
of India’s Central Bank Digital Currency (CBDC)

i) What is the Central Bank Digital Currency (CBDC)? How this currency is different
from Fiat currency. (5)

The general belief is that the digital rupee would give a ‘big boost’ to digital economy. It
was also indicated that technologies such as block chain would be used by the Central bank
to issue the currency.

ii) What is the economic rationale for introducing CBDC? (5)

iii) What are the potential benefits and challenges related to CBDC implementation? (10)
[20]
***************************

Page 3 of 3
 Institute of Actuaries of India

Subject SA7-Investment and Finance

March 2022 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates. The
solutions given are only indicative. It is realized that there could be other points as valid answers and
examiner have given credit for any alternative approach or interpretation which they consider to be
reasonable.
IAI SA7-0322
Solution 1:

i) Listed debt
 Listed debt is sold on an exchange
 Both government bonds as well as corporate bonds and asset backed securities can be listed on
exchange

Advantages
 The price is more readily available
 Theoretically, liquidity is expected to be higher than for private debt – but listed debt is not always
liquid and often seldom trades;
 Mainly because most of the issues are held by institutional investors to match their longer term
liabilities and are held till maturity; Debt securities may be a match or reference for institutional
liabilities, accounting or capital assessments
 Busing/selling decisions can be quickly made and potentially much cheaper than private debt
(compared to the potential cost of forced selling of private debt)
 Listed debt has stricter regulatory / compliance requirements
 Ratings of debt help establish individual bond issuer creditworthiness
 Investors may be limited to investment grade credit or other rating based restrictions
 Future funding requirements for borrower can be met from the broader marketplace, not just the
existing investors
 Within listed debt diversification can be more easily achieved as there are comparatively more
investment opportunities (although have reduced in recent years and issuers may concentrated in
certain sectors)
 In some advanced markets, derivatives based on listed debt can be purchased. This can potentially help
the manager with asset allocation as well as limiting negative returns (at a cost)
 Higher allocation can be made according to regulation
 Typically number of issues and their depth is larger for listed debt

Private debt
 Private debt is owned by a private group of investors, usually including the owners, management of the
company issuing the debt or a syndicate of investors providing debt based funding.
 Mostly corporate bonds that can be held privately; in some extreme cases Govt securities can be issued
only to specific investors with caveats around offloading/ selling to other parties.

Advantages
 Private debt provides diversification benefits to other asset classes
 These bonds are have less market pricing efficiency; thus offering the potential of higher returns to
compensate for lower liquidity
 Liquidity premium will also increase returns compared to listed
 Higher degree of manager influence and governance – can force borrower to agree on stricter
covenants
 Credit worthiness of the issuer may not available and even if its available, the nature of covenants may
not be available to determine the credit worthiness of the issue, investors have to perform their own
due diligence in the absence of credit rating of the issue.
 Will be difficult to hedge against market risk
[7]

Page 2 of 13
 IAI SA7-0322
ii)
a)
liquidity risk – an investment into private debt o Distribute proceeds of debt repayment directly to
cannot easily be liquidated and term of lending investors.
is subject to prepayment risk o Structure the fund in in a way that loans can be given
o if an opportunity is unwound, monies will against the investment if liquidity by investors is
be distributed back to investors required; albeit at some margin
o Similarly, recurring debt repayments may o Set minimum lockin period and and associated
be reinvested or paid to investors penalties upfront for investors.
o Set rules regarding foreclosure/ recurring repayment
o Set framework to recover as much amount as
possible in case of default
Currency risk – consideration needs to be given o The overall limit for investors to invest overseas
whether or not currency risk should be needs to be considered
included. o Set % in unlisted debt instruments for retirement
o If included it is expected to increase the funds. This limit may reduce the potential to raise
returns (due to inflation differential), the capital for the fund.
however it does increase the risk.
o If target market’s liabilities for investor are
USD denominated, then currency risk
should probably be hedged out. Though,
this will increase the cost of the fund.

Default risk – high risk of default beyond the o Is the return target sufficient compensation for the
risk appetite of the investor risk taken?
o Smaller position as part of the investor’s o Obtain credit ratings for further comfort)), or specify
overall fund can be made limits on higher risk debt; however, this might be to
o Could potentially target lower risk of the detriment of returns.
default companies

Risk return profile: Is the return target o What returns have other funds similar to this one
sufficient compensation for the risk taken? produced over the past
o How will the market differ in the foreseeable future
(for example when QE ends), and what influence will
that have on the market the portfolio manager is
operating in?
Fees: Are the fees too high – there has been o For the target market a detailed analysis of the fees
focus on fees for institutional investors will need to be provided – show total fees payable
under different performance outcomes
o How does the 1.5% compare to similar products and
how was this determined? The 8% hurdle needs to
be assessed against other funds
Operational and regulatory risk: o Audit and compliance functions need to be in place
The manager will have to prove it has the and evidence of robust management of operational
necessary processes in place to ensure that the risks including disaster recovery
fund is audited and complies with all regulation o Ideally this may be outsourced to specialist agency
for cost efficiency and in order to give investors
peace of mind
Tax implications: What will the tax implication o Design the fund be structured in a more tax effective
be for the target clients? manner considering minimum lock in, sectoral
exposure etc that make fund eligible for favourable
taxation
o The tax implication of an international fund need to
Page 3 of 13
 IAI SA7-0322
be clearly understood and communicated – i.e.
double tax relief, who reclaims withholding tax, how
will Indian/ US tax exempt investors be handled.
o The tax implications depend on the type of
institutional investor.
Legal Structure of the fund o Set the legal structure of the fund that is tax efficient
and does not dissuade potential investor to invest in
the fund.
o e.g. can buy in as a limited partner which means that
they can only lose as much as they’ve put in.
o If structured as a company, then there will be
company tax payable before the distribution of
profits/income to investors.
[7]

b)
The capital commitment phase is o A discount on fees to investors who commit capital first. This
typical and should not be perceived will also help with the marketing angle of ‘buy now before it is
abnormally low by the target too late’
market

The $10 m might be considered too o Either consider reducing the size of the overall fund, or increase
little compared to the intended size the capital commitment. This will show the potential investors
of the fund that the PM’s interest is aligned to that of the investors.
o Commit higher initial capital with drawdown as the fund reaches
threshold limit of say $100m

The reputational risk that the o This fund should only be marketed to sophisticated institutional
investors don’t understand the investors due to the financial knowledge required as well as risk
product which later causes inherent in this fund.
reputational damage o High minimum investment needs to be introduced to deter
smaller investors from accessing this fund
o Marketing material must explicitly explain all investment risks
o It would be ideal if the capital committed by the fund managers
Will the fund achieve the critical covers the critical minimum.
minimum inflow that has to be o Commitments could be obtained from a few key investors
achieved in order for the fund to be before going to market.
optimally functioning?
o Widen the net of potential investors e.g. beyond institution or
outside of India
o A list of the fund manager’s past experience and track record
Will the manager be able to sell his needs to be included in the marketing material as well as
product if he is unknown in the communicated to the potential investments (pipeline).
Indian market? o The marketing material should include why is this asset class
may be potentially more attractive than other investments
o Marketing material should also include the maximum
investment in an underlying opportunity in order to achieve
diversification and reduce concentration risk. This will be a key
risk in the beginning of the fund when only a few investments
have been made.
o The fund manager’s past performance could be used to show
Page 4 of 13
IAI SA7-0322
diversification benefit if combined with typical traditional
strategies
o The manager needs to offer something special (unique selling
point) for investors to invest in an unknown manager.
o Audit and compliance functions need to be in place and
Audit and compliance functions evidence of robust management of operational risks including
need to be in place with robust disaster recovery
management of operational risks o Ideally this may be outsourced to specialist agency for cost
including disaster recovery. efficiency and in order to give investors peace of mind

o December is generally bad month to launch as most investors

Timing of launch will be important are on holiday, March and June is most people’s year end thus
too busy to look at exotic investments

o May not get the anticipated level of returns (i.e. above 8%)
Lower return than expected which could result in low fees collected and costs not being
covered
[8]

iii) The Effective Annual Cost measure (EAC) is a standardised disclosure methodology that can be used by
consumers and advisors to compare charges on most retail investment products, and their impact on
investment returns, so that consumers are placed in a position to make better informed decisions
around retail savings and investment product choices.

Management + admin +other = 1.5%+0.5%+3% = 5%

Distribution waterfall = (20%-6%)*20% = 2.8%
Advisor = ((1+1.5%)*(1+.5%)^9)^(1/10)-1 = 0.6%
Thus EAC= 5%+2.8%+0.6% = 8.4% [3]

iv)
a)
 Economic Survey 2021-22 estimates that the Indian economy (GDP) may grow by 9.2 per cent in
real terms in 2021-22 (as per first advanced estimates) subsequent to a contraction of 7.3 per cent
in 2020-21.
 GDP is projected to grow by 8- 8.5 per cent in real terms in 2022-23.
 The year ahead is poised for a pickup in private sector investment with the financial system in a
good position to provide support for the economy’s revival.
 A combination of high foreign exchange reserves, sustained foreign direct investment, and rising
export earnings will provide an adequate buffer against possible global liquidity tapering in 2022-
23.
 The economic impact of the “second wave” was much smaller than that during the full lockdown
phase in 2020-21, though the health impact was more severe.
 The economic impact of “third wave” was minimal given the level of preparedness at all levels,
vaccination drive and milder variant.
 Government of India’s unique response comprised of safety-nets to cushion the impact on
vulnerable sections of society and the business sector, significant increase in capital expenditure to
spur growth and supply-side reforms for a sustained long-term expansion.
 The ongoing war between the Russia and Ukraine has added another layer of uncertainty in the
market. Its direct impact is visible in the fast-spiraling crude oil prices which has already risen by
~39% since start of this year and currently trading above USD 110 per barrel.

Page 5 of 13
IAI SA7-0322
 Russia plays an outsized role in the global oil market. It is the largest exporter of oil in the world
accounting for almost 8% of total world oil supply. Thus, a prolonged war or stricter economic
sanctions on Russian energy and financial sectors could put significant upward pressure on crude
oil prices
 The government’s flexible and multi-layered response is partly based on an “Agile” framework that
uses feedback-loops, and the use of eighty High-Frequency Indicators (HFIs) in an environment of
extreme uncertainty.
 Gross Tax Revenue registers a growth of over 50 per cent from April to November 2021 in YoY
terms. This performance is strong compared to pre-pandemic levels of 2019-2020 also.
 India’s merchandise exports and imports rebounded strongly and surpassed pre-COVID levels
during the current financial year. There was a significant pickup in net services with both receipts
and payments crossing the pre-pandemic levels, despite weak tourism revenues.
 As of end-November 2021, India was the fourth-largest forex reserves holder in the world after
China, Japan and Switzerland.
 Economic Survey 2021-22 notes that the liquidity in the system remained in surplus.
o Repo rate was maintained at 4 per cent in 2021-22.
o RBI undertook various measures such as G-Sec Acquisition Programme and Special Long-
Term Repo Operations to provide further liquidity.
 The average headline CPI-Combined inflation moderated to 5.2 per cent in 2021-22 (April-
December) from 6.6 per cent in the corresponding period of 2020-21.
 The decline in retail inflation was led by the easing of food inflation.
 Food inflation averaged at a low of 2.9 per cent in 2021-22 (April to December) as against 9.1 per
cent in the corresponding period last year.
o Effective supply-side management kept prices of most essential commodities under control
during the year.
o Proactive measures were taken to contain the price rise in pulses and edible oils.
o Reduction in central excise and subsequent cuts in Value Added Tax by most States helped
ease petrol and diesel prices.
 Rupee has fallen in value significantly against the US dollar
 Large Government GSEC issuance as part of policy to stimulate the economy ; Increasing issuance
of government debt may crowd out private investment debt
Key concerns:
 The Russia/Ukraine conflict continues to escalate.
 Inflation rises in a disorderly way, negatively affecting asset values.
 Policymakers remove accommodation too rapidly, undermining the global economic expansion.
 COVID-19 cases increase, including any new variants like omicron+delta.
[5]

b)
US –
Equity Market
 S&P 500 performance for February (-3.14%) followed January (-5.67%) on the downside
bringing its YTD return to -8.23%.
 While the market continued to adjust (reallocate) itself for an expected slower (and more
expensive) economy.
 Ukraine situation dominated the moral headlines and wreaked havoc on the market, with a
knee-jerk reaction to an expected event, it was the economy that ruled the market.
 And for February, the economy was defined by increasing inflation stats (7.5% CPI, 9.7% PPI,
and 6.1% PCE) and oil's return to USD 100 (last seen in July 2014).
 Latest loss in S&P was blamed mostly on inflation, as it overtook COVID-19 on the concern list.

Page 6 of 13
IAI SA7-0322
 For most of this month, global conflict replaced inflation (through the correction entry), but
inflation (costs of materials, labor, pass-throughs, etc.) reappears a smain driving force, slightly
beating out second place global conflict, with COVID-19 a distant third.
[Max 1]
Bond Market
 The 10-year U.S. Treasury yield spiked 81 basis points over the first quarter to end the period at
1.74%.
 However, as the economic recovery became bumpier and inflation continued to rise, the yield
curve partly retraced the first quarter's steepening over the remainder of the year.
 Short-term yields modestly rose, while the 10-year yield declined to 1.52% by the end of 2021.

o Fed Tightens Policy Amid Rising Inflation

o Credit Investors Hunt for Yield
o Strong Dollar Weighs Down Global Returns
o Demand for Municipal bond continues

 Performance across fixed-income Morningstar Categories was mixed as more-credit-sensitive

strategies outpaced most of the pack, while interest-rate-sensitive and non-U.S. dollar-
denominated bond funds posted losses.
 High-yield municipal funds led the way, with an average return of 5.7%, while emerging-
markets local-currency bond funds plunged 7.3% on average.
 The Morningstar U.S. Core Bond Index, a proxy for typical U.S. bond exposure, fell 1.6% for the
year, posting its worst calendar-year return since the taper tantrum roiled fixed-income
markets in 2013.
[Max 1.5]

India
Equity:
 New strains of Covid-19, vaccination coverage, the U.S. Federal Reserve's timeline for tapering
monetary stimulus, inflation, work-from-home, and retail investor frenzy shaped the equity
markets in 2021.
 India's stock benchmarks were the top performers among global peers as they scaled new
records.
 That rubbed off on the primary market with Indian companies raising a record amount via
initial public offerings.
 The markets, however, ended the year volatile, having retreated from their October peak.
 All the nine sectoral indices on the NSE rose in 2021. The NSE Nifty Metal Index rose the most
followed by Nifty IT Index and Nifty Realty Index. Bank, FMCG and pharma indices gained the
least, but those gains were also at least 10%, as in the case if Nifty FMCG.
 While foreign inflows drove the markets higher till February, domestic institutional investors
came to the rescue after the second wave of Covid-19.
 With concerns over faster withdrawal of monetary stimulus and the Omicron strain, the DIIs
kept the markets afloat, undeterred by the FII outflows.
 India's stock benchmarks were among the top performers among the global markets in 2021.
[Max 1]

Bonds:
 Economic Survey 2021-22 notes that the liquidity in the system remained in surplus.
 Repo rate was maintained at 4 per cent in 2021-22.
 RBI undertook various measures such as G-Sec Acquisition Programme and Special Long-Term
Repo Operations to provide further liquidity.
 The economic shock of the pandemic has been weathered well by the commercial banking
system:
Page 7 of 13
IAI SA7-0322
 YoY Bank credit growth accelerated gradually in 2021-22; from 5.3 per cent in April 2021 to 9.2
per cent as of 31st December 2021.
 Bond market has been quite volatile in 2022 so far. The 10-year government bond yield which
was hovering around 6.35% during December 2021, spiked to 6.95% (on February 4, 2022) in
the aftermath of Union Budget; and is currently trading around 6.80%.
 The volatility in the bond market can be attributed to -
- hawkish US FED policy projecting series of rate hikes and liquidity reduction
- rising crude oil and other commodity prices
- higher than expected fiscal deficit and market borrowings by the Central Government
 Interest rates/bond yields moved up. While the RBI held the policy rates unchanged and
delivered an ultra-dovish policy statement indicating continuation of the current easy monetary
policy regime for a longer period.
 Government borrowing has more than doubled in the last three years The central government
has pegged its gross market borrowing in FY 2022-23 at Rs. 14.95 trillion vs 10.46 trillion in FY22.
To recall, the government borrowing was around Rs. 7.1 trillion in FY20 (before the pandemic)
which jumped to Rs. 12.6 trillion in FY21. It is already much higher than natural market appetite.
 Notwithstanding this fact, the bond market was well behaved in the last two years due to –
(1) easy monetary policy and increasing liquidity surplus,
(2) large bond purchases by the RBI and
(3) increased demand from banks due to HTM relaxation [Max 1.5]
[Max 5]

v)
 Performance fees is normally used to reduce conflict of interest between fund manager and
client and align both parties interests to the outcome of the fund.
 However, it may lead to inappropriate behaviour by investment managers if performance fee is
structured incorrectly or ambiguously.
 There is no incentive for the manager to manage downside risk and the manager will seek to
maximize the fund returns with little consideration for the potential downside risk. There is no
downside participation by the manager if the fund underperforms; passing on the entire risk to
the investors.
 Although the fund does not have an benchmark portfolio to assess relative performance, three
is still misalignment of nature of return on underlying (USD) investment to that of flooring of
WPI + 5%.
 The flooring benchmark should ideally be have same nature as that of the underlying
investment, i.e USD denominated and having linking to US inflation.)
o a US denominated index based on debt instruments may be used for benchmark. Some
adjustment might be required (either adding or subtracting a certain %) to adjust for the
risk of underlying debt instruments compared to the benchmark.
o Whichever benchmark is chosen, it should be transparent and readily available; which in
this case is fine as WPI index is regularly published by a government agency.
 There is no cap on sharing the returns if the fund outperforms.
o We may introduce a cap on the sharing outperformance; this will have some barrier
towards risk seeking behaviour of manager
o Alternatively, a rebate could be introduced as compensation if certain hurdles have not
been achieved
 Introduce a high water mark in order to avoid the manager achieving fees twice e.g. if the fund
grows from in certain year the manager will get the performance fee, if fund falls to original
level or below and again grows to higher level, manager could potentially get similar
performance fee for no significant benefit to investors.
 A period longer than one year for rolling return might be better (barring 1st and 2nd year) .The
shorter the period, the more performance could be attributed to luck and high chances to fund

Page 8 of 13
IAI SA7-0322
getting fee twice for same return if underlying investment show cyclical returns over rolling
period.
 The one year measurement period is also short, considering the fact that underlying
investments are expected to be of much longer term.
 If WPI is 5%, this fee will be 2%+max((20%-10%),0)*20% = 4%. It is slightly higher than the 4%
expected from management fees above. If WPI is 15%, this fee will be 2%+max((20%-
15%),0)*20% = 3%. If WPI is above 20%, then fee is floored to 2%. Unless the return from
underlying investment increase with benchmark, there is risk to the fund manager that the
inflation may increase drastically leaving lower fee – another reason not to use the WPI
benchmark.
 Having alternative fee structures available to investors will be suit different types of investors
and could be used as a marketing tool
 Whether this fee is appropriate could be determined by comparing it to other similar funds in
the market; if the fee is significantly higher than similar funds, than it will be difficult to sell the
product and find enough subscibers.
 However, 20% participation should not be seen as excessive as it is in line with market norms,
particularly in comparison with hedge funds and fund of funds.
 Compared to flat fees, performance fees are very complicated. Portfolio managers can have
different interpretation of wording and can have legal implications.
 Performance fees can be difficult to explain to stakeholders including Trustees and members.
Flat fees are more transparent although significant.
 Administration of performance fees is complicated and mistakes are easily made. Checks are
required
 Performance fees are unpredictable compared to flat fees
 The charging structures does not include an initial fee, for a new start-up company it might be
appropriate to have an initial fee in order to cover set-up costs.
 The base fee will might encourage the manager to try and gather as much assets as possible
without consideration for the fund capacity.
 The base fee could be justified by the fact that managing private debt fund is lot more labour
intensive and more due diligence is required
 Flat fees are more in line with treating customer fairly ( TCF), although TCF is an evolving
concept and have not fully rooted in fund management industry in India.
 Returns might be compromised if the fund grows too big, however since it is based in the US,
capacity should not be an issue

[5+5=10]
[45 Marks]
Solution 2:

i) Professional and Amateur investors analyse investments differently. Their analysis and behavioural
aspects may be different with regard to the following (1mark for each valid point with explanation)
1. Amateur investors have relatively short term investment horizon while professional investors will
have long-term investment time frame.
2. Amateur generally invests for earning quick money on listing, Professional finds best investment
opportunities to compound wealth consistently and patiently.
3. Amateur investors get panicky when stock market is volatile while Professional investors show
patience and consistency.
4. Amateur listen to random advice and takes their investment decision, Professionals have his full-
time trustable advisor on whom he can rely and discuss to make the decision for his investments.
5. Amateur tries to time the market based on sentiments, emotions, etc. Professionals stick to their
strategy no matter what are the sentiments or their emotions.

Page 9 of 13
IAI SA7-0322
6. Amateur read news, noise & information. Professionals read books, experiences, case studies,
behaviours, and reports.
7. Amateur deviates from their initial strategy if someone suggests something new, Professionals
know that they have started their strategy based on its fundamentals and have faith in it. So, they
won’t change it until they actually achieve their goals.
8. Amateur investors may be influenced by the discount while professional investors will consider
discount vis-à-vis the value of the share.
9. Amateur might have a confirmation bias based on their own thought narrative. They will try to find
out information about the company that they want believe.
10. Amateur investors may might think of this investment in a large government owned life insurance
companies as secure without realising the management capability and long term prospects of the
firm due to high competition in the market.
[10]

ii) 1 mark for each valid point with explanation

 Overconfidence: Overconfidence Bias results in false sense of understanding due to

overconfidence. The researcher may have overconfidence regarding his research abilities and he
may think that his research is perfect and his investments will not have any downside risks. His
select past experience may have made added to his confidence.
 Regret Aversion: The avoidance of future possible regrets may lead to bias. In this case, the bias
may be that is we do not invest in this company, this will be a case of lost opportunity. The bias
may also come in due to fear of being wrong.
 Oversimplification - Investing in the company based on the fact that it is Government owned and
that is the largest life insurance company is a sure shot success strategy without diving much deep
into the financials.
 Status Quo - May prefer to keep the investment as is even if the investment is not appropriate.
 Confirmation Bias: Confirmation Bias results in interpreting any information obtained as confirming
existing analysis.
 Hindsight Bias: Hindsight bias results in interpreting events that occurred in the past being more
likely than they actually are.
 Conservatism Bias: Conservatism Bias results in lower expectation due to misplaced fear of over
estimation.
 Anchoring and Adjustment bias: The initial analysis may be based on detailed review, however any
subsequent advice based on new information without a comprehensive review results in anchoring
and adjustment bias.
 Availability Bias: This results while assuming that the available information is they only available
information.
[7]

iii) Risk Appetite depends on a number of factors. The investor in this context is an amateur high net
worth Investor aged 65 years.

It can be assumed that this investor would have a diversified portfolio and must be taking investment
advisory from a professional investment advisor.

I think he would have reasonable level of risk appetite and risk capability but investment strategy may
depend on other conditions such as his assets, liability, financial goals.

The HNI investor might not want volatility in investment returns. In this context, a life insurance fund
would be a better option as it offers diversification through investment in other private life insurance
along with investment in the company he wants to invest.
Page 10 of 13
IAI SA7-0322
Directly investing in the company may be little cost effective and may give him better control on the
management of investments. However, investment through funds would be more desirable as the fund
would monitor investments actively and reallocate investments with changing scenario.

There may be some exit loads in case of funds.

Equity returns and mutual fund return might be subject to different taxation rules.

[5]

iv) Lifecycle investments are investment strategy which are aligned to the risk appetite and risk capability
of an individual. Generally, investors change their investment allocation from high risk investment to
low risk investment as they grow old.

It is based on the concept that investors may have aggressive investment approach initially with high
risk high return paradigm and can move to less risky assets with conservative approach to preserve
their capital.

My advice to the client would be to invest in equity fund of an Asset management Company who has
investments in other insurance companies as well. This advice would also depend on the client's
liability, lifestyle, financial goals etc.

[3]

v) (max 3 mark for each category of performance measure with explanation)

Absolute Performance Measurement. – This can be done for a fund as a whole or/and for individual
asset categories or individual investments. The measurement tool could be Internal rate of return or
any other absolute measure.

Relative Performance measurement - Relative to –

 An investment index
 A notional benchmark fund and
 A specified universe of other funds

The performance measurement process begins with the selection of an appropriate benchmark that will
be subsequently used to assess the performance of a portfolio

Excess return is the difference between a portfolio’s return and its benchmark’s return. Excess return
can be calculated arithmetically or geometrically:

Performing a Risk Analysis

Risk analysis is important for those who are responsible for both managing and controlling the
portfolio’s risk. Risk managers view risk positively. Basic risk measures can be divided into three
categories:

 Absolute risk measures, such as standard deviation, the Sharpe ratio, and M2.
Page 11 of 13
IAI SA7-0322
 Relative risk measures, such as tracking error and the information ratio.
 Regression, which measures the alpha, beta, and standard error of the portfolio’s return.

Performance Attribution Analysis

Performance attribution quantifies the relationship between a portfolio’s excess returns and the active
decisions of the portfolio manager. In other words, it relates the excess returns of the portfolio (both
positive and negative) to the active investment decisions of its manager.

There are three main types of attribution:

 Returns-based attribution, which uses factor analysis.

 Holdings-based attribution, which is calculated on a periodic basis and uses holdings data.
 Transactions-based attribution, which is calculated from holdings and transactions data

Against Liability:

 Change in assets with respect to liabilities.

 Is there any change in liability nature, term, currency and certainty from initial allocation.
[10]
[35 Marks]

Solution 3:

i) (1 mark for each valid point with explanation)

 CBDC is the legal tender issued by a central bank in a digital form.
 CBDC is the same as currency issued by a central bank but takes a different form than paper.
 It is sovereign currency in an electronic form and it would appear as liability (currency in
circulation) on a central bank’s balance sheet
 CBDCs is exchangeable at par with cash.
 CBDC is a digital or virtual currency but it is not comparable to the private virtual currencies that
have mushroomed over the last decade
 It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency. Only its
form is different.
 Transactions are processed and recorded on a blockchain, which is a public, distributed ledger.
[5]

ii) The rationale includes the following (1mark for each valid point with explanation)
 We may seek to popularize a more acceptable electronic form of currency to improve economic
and financial inclusion
 To make issuance more efficient particularly in the Jurisdictions with significant physical cash
usage
 To meet the public’s increasing need for digital currencies
 The increasing demand is manifested in the increasing use of private virtual currencies. This will
avoid the potentially more damaging consequences of such private currencies.
 To reduce settlement risk in the financial system
 This will potentially enable a more real-time globalization of payment systems
 This will cost-effective payment systems
[5]

iii) Introduction of CBDC has the potential to provide significant benefits, such as
Page 12 of 13
IAI SA7-0322
 reduced dependency on cash,
 higher seigniorage due to lower transaction costs
 reduced settlement risk.
 more robust, efficient, trusted, regulated and legal tender-based payments option.

There are associated risks, no doubt, but they need to be carefully evaluated against the potential benefits.

 India’s high currency to GDP ratio holds out a great benefit of CBDCs. The cash usage can be
replaced by CBDCs, the cost of printing, transporting, storing and distributing currency can be
reduced.
 CBDCs can cause a reduction in the transaction demand for bank deposits. Since transactions in
CBDCs reduce settlement risk as well, they reduce the liquidity needs for settlement of transactions
(such as intra-day liquidity).
 At the same time reduced disintermediation of banks carries its own risks. If banks begin to lose
deposits over time, their ability for credit creation gets constrained.
 Since central banks cannot provide credit to the private sector, the impact on the role of bank
credit needs to be well understood
 Availability of CBDC makes it easy for depositors to withdraw balances if there is stress on any
bank. Flight of deposits can be much faster compared to cash withdrawal.
 CBDC ecosystems may be at similar risk for cyber-attacks as the current payment systems are
exposed to.
 Further, in countries with lower financial literacy levels, the increase in digital payment related
frauds may also spread to CBDCs.
 Ensuring high standards of cybersecurity and parallel efforts on financial literacy is therefore
essential for any country dealing with CBDC.
 Absorption of CBDCs in the economy is also subject to technology preparedness.
 The creation of population scale digital currency system is contingent upon evolution of high speed
 internet and telecommunication networks and ensuring the wider reach of appropriate technology
to the general public for storing and transacting in CBDCs.
[10]
[20 Marks]

*****************

Page 13 of 13
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

1st September 2021

Subject SA7 – Investment and Finance

Time allowed: 3 Hours 30 Minutes (14.30 - 18.00 Hours)

Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions to examinees sent along with hall ticket carefully and
follow without exception.

2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.

3. Mark allocations are shown in brackets.

IAI SA7-0921

Q. 1) The Board of a life insurance company has decided to invest in privately held unlisted
companies particularly start-ups with innovative product or process to diversify its
investments across asset classes. The Company’s CEO has asked its Chief Investment
Officer (CIO) to make an investment strategy document and process for investing in this
asset class keeping in mind the risk-return trade-off.

i) What drives Investment strategy of a life insurance company? (2)

ii) Please prepare a document for the board highlighting objectives, strategy and process
for investment in privately held unlisted companies. (12)

The investment process regards to valuation and due diligence needs special consideration
as these companies are privately held and unlisted. Valuation Process for these companies
may require some innovative approach to project the cash flows and arrive at future growth
assumptions.

iii) Explain the information required for valuation of the companies. (6)

The CIO has identified two start-up companies one in FinTech domain and the other one in
Travel industry (travel portal). According to the CIO these investments are good
investments considering their business model, financial plan and experience of the
promoters. The CIO is also aware of the fact that such investments are risky and require a
proper fundamental analysis to assess the company and worth of the shares. At the present
time the analyst believes that due to Pandemic, the FinTech company will perform better
while travel portal company may continue to experience slowdown.

iv) Explain how the economic scenario described above and other factors that may affect
the performance of FinTech Company and Travel Portal. (10)
[30]

Q. 2) The growing importance of ESG or environmental, social and governance in India is now
also being reflected in the capital-raising plans of India. A technology company wants to
raise funds.

i) You are an ESG expert and a technology company has asked you to plan a 5 year ESG
vision and ambition for the company. Please identify possible vision and action points
on each of the 3 components - environmental, social and governance. (12)

ii) Explain the various stages of ESG investment process. (12)

[24]

Q. 3) The board of directors of a large investment firm that has significant presence in domestic
market has been concerned for some time that the scope for continued growth in the
business is becoming more limited due to changing market place. The investment firm has
been focussing on conventional equity and bond investment management and provided its
services primarily for institutional investors.

You are working as an investment consultant to a specialist in the firm. The board is now
actively considering setting up a hedge fund operation. You have been asked to compile a
report, which will set out key factors that must be considered before embarking on the new
strategy. In particular, your report should set out the following:

Page 2 of 3
IAI SA7-0921
i) List down some of the factors that may have impacted the growth of the firm listing
giving specific examples from developments in Indian market/economy. (6)

ii) List some of the key characteristics of hedge funds and some of the structures that are
commonly available in the market. (7)

iii) The advantages and disadvantages of the various methods open to the board for entering
the hedge fund market. (12)
[25]

Q. 4) A medium size Indian life insurance company is a specialised insurer dealing only with
annuity business and have significant portion of liabilities in the form of pensions in
payment to existing annuitants. Assets backing this liability are ring-fenced and are
currently invested in an actively managed bond portfolio, with a small allocation to an
index-linked equity portfolio. The insurer has always been fully solvent meeting all
regulatory norms, but a recent valuation shows that the solvency levels has fallen below the
regulatory minimum.

i) Suggest the main possible reasons that may have led to the solvency level falling below
regulatory minimum. (4)

The board has expressed concern at the recent valuation results. The company’s financial
director has suggested that the fund adopts a more closely matched investment strategy for
the assets backing the liabilities. She has already held discussions with the leading
investment consulting firm who has suggested that the fund should enter into an interest
rate swap in order to hedge the liabilities.

ii) Explain how interest rate swaps can be used to hedge the investment risks associated
with the annuity portfolio. (4)

iii) Discuss the main issues that the trustees should consider before deciding to hedge using
swaps, as well as the advantages and disadvantages of the consultants proposal. (10)

iv) Please outline the types of derivatives allowed by IRDAI along with the purpose for
which they are allowed. (3)
[21]

***********************

Page 3 of 3
 Institute of Actuaries of India

Subject SA7-Investment and Finance

September 2021 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates. The
solutions given are only indicative. It is realized that there could be other points as valid answers and
examiner have given credit for any alternative approach or interpretation which they consider to be
reasonable.
IAI SA7-0921
Solution 1:

i) investment strategy Drivers

 The investment strategy document covers the basic principles of compliance with investment
regulations, Security & safety, yield & liquidity of investments, and meeting return expectations of
policyholders & shareholders.
 The investment strategy is also driven by prudent risk management strategies and asset- liability
management. For the non-linked products, the investment strategy addresses the twin objectives of
meeting the guarantees and maximizing discretionary benefits through a mix of investments. For
linked products, the strategy is to maximize the value of underlying assets, keeping in mind the
investment objectives and risk profile of the respective funds.
[2]

ii) The objective of the document is to assist the Board to understand the objective of investment in start-
ups, strategy and process may include the following:

• Define Investment objectives for investment in start-ups - Risk and Return

• Why the company should take this level of risks
• Risk Appetite – Understanding the risk appetite
• Is the investment risk aligned with the risk appetite of the company?
• Is this investment aligned with the investment guidelines for insurance companies?
• Is it included in Permissible Investments
• Organisational governance structure
• Define and assign the responsibilities of various teams such as research team
• Whether equity research team has the capability to assess investments in start ups
• Does company have sufficient sector knowledge
• Process for investment management – buy and sales for this asset classes
• Exceptions management
• Review of Investment performance
• Performance benchmarks for such investments
• Format for review of investment
• Format for presenting investment summary
• To weigh the diversification benefit vis-à-vis liquidity for start ups
• Ensure that measures are in place to adhere to all investment regulatory norms
• Legal and compliance – format of shareholders agreement
• Various clauses withing the agreement to mitigate the risks associated with investments in start-
up.
• Board position in the start-ups.
[12]

iii) All information related to the companies, including but not limited to past, future and quantitative
information’s

 Corporate Profile – Brief note on the companies

 Business Plan
 Past financials of the company
 Management approved projections
 Brief note supporting innovation, improvement and scalability
 What is the problem the start-up is solving
 How does your start-up propose to solve this problem
 Details of products and/or services.
 Details of the promoters.

Page 2 of 8
IAI SA7-0921
 Profit drivers, cost drivers an risk factors
 SWOT analysis of the company
[6]

iv)

 Fintech company is a good sector to invest in due to increasing digitalisation – Fintech companies are
those who use] technology for offering financial products to people at large. The increasing focus on
digitisation and work from home compulsions have created a space for innovations in the areas of
product, services or delivery process.
 Financial Inclusion focus of the government will be positive for Fintech Companies
 Lower cost of delivery of services through fintech platform will be positive
 Awareness about financial discipline and financial planning will favour fintech start ups
 Higher Financial savings may help Fintech Companies
 Stock market trends may be helpful to Fintech in trading areas
 New trends such as peer to peer lending is also helping Fintech to grow.
 Travel is a cyclical/seasonal sector and will be strongly affected by the economic cycle – Travel industry
is a profitable sector but is a seasonal and cyclical sector.
 Due to ongoing pandemic and restrictions, the spend on travel will not increase in near future and so
the outlook for this sector is not very bullish.
 Increasing need for liquidity will impact discretionary spending such as travel- People would prefer
liquidity in this uncertain times and so the spend on travel might come down.
 Personal taxation will also impact the disposable income and so the spending –
 International travel restrictions will impact travel industry
 Regulatory risk on start-ups – The regulations for start-up is still emerging and there may be many grey
areas which might impact the start-ups.
 Tax issues such as angel taxation for start ups
 Business risk and operational risk associated with the companies
 Inflation will also impact
 Political Scenario in the country will impact both the sectors.

[10]
[30 Marks]
Solution 2:

i) ESG Vision and Action Points

Environmental Vision: Serve the preservation of our planet by shaping and sharing technology solutions
 Leverage technology to support the transition to a low-carbon world
 Maintaining carbon neutrality missions every year
 Reducing absolute greenhouse gas (GHG)
 Reducing absolute GHG emissions
 Engaging clients on climate actions through our solutions
 Reduce our water footprint and enhance water availability in the communities where we operat
 Maintaining 100% wastewater recycling every year
 Reduce, reuse and recycle to minimize waste, including e-waste
 Ensuring zero waste to landfill

Social Vision: Serve the development of people by shaping a future with meaningful opportunities for all
 Enabling digital talent at scale: Facilitate skilling to ensure progress for all

Page 3 of 8
IAI SA7-0921
 Diversity and inclusion- Foster diversity and nurture inclusion
 Energizing local communities: Enable opportunities for communities locally
 Tech for good- Partner with society to harness the power of technology solutions in their everyday
 Employee wellness and experience: Ensure fulfilling careers for our employees

Governance Vision: Serve the interests of all our stakeholders by leading through our core values
 Corporate governance Be a leader and get benchmarked for world-class corporate governance
 Data privacy Ensure the safety of stakeholder data
 Information management- Uphold the digital trust of our stakeholders
[12]

ii) ESG investment approaches

ESG considerations are relevant to all asset classes and at all stages of the investment process:
 Investment objectives – Some investors may have ESG-related objectives, such as having a positive
social or environmental impact through their investments.
 Investment beliefs – These include beliefs about the way ESG factors will affect investment markets
and the extent to which different investment management techniques can capture those effects.
 Asset allocation – ESG factors may affect the expected returns and volatility of those returns over
the long-term, so should be considered when parameterising asset-liability models. Investors may
wish to avoid or seek out certain asset classes for ESG reasons (for example, some may view
commodity mining as problematic from an ESG perspective if it is linked to poor human rights
standards).
 Manager selection and monitoring – If external asset managers are appointed, then their ESG
beliefs, expertise, policies and processes can form part of the selection process. Any specific ESG
requirements should be documented in the investment management agreement. Ongoing
monitoring can ensure these requirements are met and that ESG policies and processes are being
implemented effectively.
 Security selection – Analysis of possible investments can include consideration of ESG factors (see
section 4.4 below).
 Portfolio construction and monitoring – The overall ESG characteristics of the portfolio can be
studied using individual metrics such as greenhouse gas emissions or aggregate ratings covering
groups of ESG factors. This can help to manage aggregate exposures to ESG risks and opportunities.
 Exercise of ownership rights – ESG topics are frequently a focus of voting and engagement activities
(see section 4.5 below). Investors may use engagement to obtain ESG information that can inform
their investment decisions and/or to encourage companies to adopt better ESG practices.
[12]
[24 Marks]

Solution 3:

i) The following points should be mentioned:

 SEBI lowering FMC charges that can be levied to mutual funds
 IRDAI putting pressure on fee levied by insurers via indirectly capping the yield reduction
 Online platforms leading to lowered transaction costs for retail and thus impacting institutional
investors
 Impact on currency replacement by GOI that let to liquidity crunch and reduced confidence towards
traditional investments
 Soft commissions to channel partners
 Unbundling of research and increased cost of research
 Passive increasing market share,

Page 4 of 8
IAI SA7-0921
 Increased focus and scrutiny by regulators putting downward pressure on fees.
 Increased competition from international houses
 Increased competition from new products impacting traditional funds
 Smaller firms will be impacted more than large ones
 Problems in finding, training and retaining key staff
 Problems in delivering expected returns to shareholders
 Poor absolute returns in recent years
 Poor relative returns from balanced funds
 Lower forecast future returns impact profitability of managers
 Move to passive, fund of funds, hedge funds , specialists, increased bond exposure
 Increased interest in alternatives
 Alternative investments are less developed asset class = opportunity
 Higher fees available
 Performance fees often becoming the norm
[6]

ii) The key characteristics are

 More emphasis on absolute returns
 Returns not solely a function of underlying assets
 Limited downside often a feature
 Extensive use of all investment instruments
 Diversification due to low correlation with bond/equity returns
 Make use of short selling, stock lending, gearing, arbitrage
 The main types are
 Long and short equity/bond funds (specific asset classes)
 Long and short strategies based on futures/options worldwide
 Global opportunities - speculative investments
 Relative value funds - exploitation of perceived anomalies
 Event driven - takeover, merger, political
[7]

iii)
Run underlying hedge funds directly
Advantages
 full fee income captured
 direct control of investment process and performance

Disadvantages
 takes time to build track record (longer time than fund of funds)
 no brand image
 seed capital required
 specialist staff require to be hired
 infrastructure required to manage new product
 timeframe for building successful business may be short

Run fund of funds that constructs portfolios of hedge funds run by other houses
Advantages

Page 5 of 8
IAI SA7-0921
 less costly to set up
 quicker to set up
 less infrastructure needed
 more immediate choice to customers (product tailored)
 performance risks spread over different organisations and strategies
 Disadvantages
 lower fees
 less control of customers (could go direct)
 needs manager research process to be set up
 less investment control

Set up a Joint Venture with hedge fund manager

Advantages
 good hedge fund brand will allow sales sooner (track record)
 infrastructure and management expertise in place

Disadvantages
 less control
 share of fees
 exit/development strategy needed
 knowledge transfer
 brand dilution/confusion
[12]
[25 Marks]
Solution 4:
i)
 Unaffordable annuity increases have been granted in the past
 The valuation basis may have been changed to one which places a higher value on the value of liabilities
 Or a different value on the value of assets (for example a change from an adjusted long term value of
assets to market value)
 Assets may have underperformed expectations since the last valuation on bond manager
underperformed due to credit or duration positioning,
 Equity markets may have suffered a significant correction (relative to the size of the previous surplus)
 Interest rates may have changed significantly and the duration of the bond portfolio is quite different to
that of the liabilities.
 The valuation rate used to value the liabilities may be unrealistically high compared to the underlying
assets
 Mortality assumptions may have been too optimistic and pensioners are living longer than anticipated in
the valuation basis.
[4]
ii)
 An interest rate swap is a derivative instrument whereby one party swaps floating rate payments for
pre-determined fixed rate payments with another. The counterparty to the swap investor is a bank.
 They are OTC instruments and can be tailored to the needs of the investors.
 The fund would need to determine the liability profile for the pensioner pool – calculating the expected
cashflows going forward in respect of pension payments.
 The main investment risk associated with the fund are interest rate and inflation risk.
o Both can be managed by using swaps – to receive inflation-linked payments and/or extend the
duration of the asset portfolio.

Page 6 of 8
IAI SA7-0921
 From this the duration or interest rate sensitivity of the liability can be determined.
 The fund would then enter into a swap to pay floating and receive fixed payments
 The fixed rate payments can be tailored to hedge the interest rate risk exposure of the fund (by
matching cashflows and/or duration)
 An overlay may be applied to hedge against inflation risk. In other words a swap whereby one party (the
pension fund) pays fixed and the counterparty pays inflation linked payments.
 Margin makes leverage possible requiring lower immediate outlay to hedge a given exposure than
compared with a portfolio of government bonds. It is also possible to hedge liabilities for which no
natural physical asset hedge exists
 Swaps can be collateralized but do not have to be – which leaves the investor exposed to bank credit
risk. Two-way collateralization requires management and available acceptable liquid assets
[4]
iii) Considerations:
 What is the valuation basis used to value the liabilities –
o is it with reference to the inflation linked or nominal yields,
o and does it use a single point yield or a yield curve
 The timing of the decision to change to a matched strategy is important. Consider current pricing of
bonds and swaps in the market.
o Bond yields are currently high due to fiscal uncertainty and it may be a good time to take
advantage of this
 How to manage the change and any required disinvestment of existing assets. It is likely that there
may be illiquidity in the bond portfolio should significant assets be realized.
 Moving to a more passive LDI strategy would mean giving up additional alpha generated by the
bond manager – which may be necessary to fund pension increases
 What is the pension increase policy and past practice in terms of pension increases? Do we need to
hedge against inflation as well as interest rate changes?
 What portion of the assets would you want to allocate towards the hedged component versus the
unmatched component.
o An ALM exercise will help determine the degree of risk mitigation or matching required
o Consider the funding level and the current pricing of swaps.
 Will entering into a swap be permissible in terms of regulations as swaps are considered derivatives
 Does the fund’s rules allow for use of swaps/derivatives. Will the IPS need to be changed.
 Do the trustees (and/or their actuary or asset consultant) have the expertise required to enter into
and manage such a complex arrangement
 The fund is very large and may wish to split the swap overlay amongst a range of banks in order to
mitigate risks. One bank may be unable/unwilling to take on the entire swap. How do you select,
monitor and manage counterparties?
 What other hedging mechanisms are available to be considered – e.g.: repos, cashflow matching,
other actively managed LDI opportunities

Advantages:
 Will immunise the fund against interest rate risk (and possibly inflation risk) provided that the
valuation basis is consistent with the interest rates being hedged
 The liability exposure to interest rate risk can be fully hedged without using all the funds existing
assets
 Swaps are OTC and can be tailored to closely hedge the portfolio
 If longer term government yields are historically high relative to floating rates you may be able
to lock into a higher fixed component

Page 7 of 8
IAI SA7-0921
 Can hedge very long term liabilities – swaps of longer than 50 years can be entered into

Disadvantages:
 There may still be “basis risk” between the valuation of the swap and the liabilities which cannot
be perfectly hedged
 Liabilities may be measured off a bond curve not a swap curve
 Trustees will be locking into lower returns compared to the active bond portfolio
 Credit risk with the counterparty bank – even if it is a collateralized swap (how often is MTM
done?)
 Will need cash for margin/collateral - especially if interest rates move significantly out of your
favour
 Short rates may increase suddenly while longer term rates remain fixed
 Fund will be locked into a very long term agreement
 There may be an exit clause but this will come at potential significant cost
 Cost of the swap - can be quite expensive depending on position of swap curve relative to bond
curve
 Legal risk – swaps are unique OTC instruments which leads to information asymmetry between
parties and potential risk for the fund.
 Early termination may be exercised by the bank – in which case the fund will lose its hedge and
will need to replace this with another –perhaps at worse terms
 Operational risk associated with such a complicated structure is quite high (ie mark to market,
margining process)
 Future changes in banks (or pension funds) risk and capital requirements may require derivative
to be unwound or reset on disadvantageous terms
 May require ongoing monitoring of the swap in order to maintain the hedge
[10]

iv) Insurers are allowed to deal as user with following types of Rupee Interest Rate Derivatives to the extent
permitted, and in accordance with the IRDAI guidelines.

i) Forward Rate Agreements (FRAs);

ii) Interest Rate Swaps (IRS); and
iii) Exchange Traded Interest Rate Futures (IRF).

Permitted purpose of Dealing in Interest Rate Derivatives:

Hedging for forecasted transactions:

a. Reinvestment of maturity proceeds of existing fixed income investments;

b. Investment of interest income receivable;
c. Expected policy premium income receivable on the Insurance Contracts which are already underwritten
in Life and Pension & Annuity business in case of Life Insurers and General Insurance business in case of
General Insurers.

The overriding principle of any use of the above listed derivatives is that they must be used for hedging
purposes only to reduce the interest rate risk in the company. The company must be able to
demonstrate that this principle is adhered to.
[3]
[21 Marks]
*********************

Page 8 of 8
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

23rd March 2021

Subject SA7 – Investment and Finance

Time allowed: 3 Hours 30 Minutes (14.30 - 18.00 Hours)

Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions to examinees sent along with hall ticket carefully and
follow without exception.

2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.

3. Mark allocations are shown in brackets.

IAI SA7-0321

Q. 1) You are a group Actuary primarily responsible for investment department of large life
insurance company which is also a subsidiary of a large private sector financial institution. The
institution has other operations including banking, general insurance, asset management
company, specialised home loan company, private equity and investment banking etc. The
client base of the conglomerate is quite diversified and includes appropriate proportions of
low, middle and high income category. The subsidiaries are closely linked and able to cross
sell products across the all subsidiaries. The group mandates its subsidiaries to provide
financial products catering to the needs of each category of its clients.

The group CIO (Chief Investment Officer) organised a meeting with his team to review the
compliance with above mandate and proposed the following agenda:

- Recent developments in investment strategy which may be adopted by company

- The investment strategy for the most popular product in high income category
- Investment strategy for a new product designed by the regulator for low income
category
- Alignment of interest between the life insurance company and AMC subsidiary of the
bank.

The meeting was held and CIO gave some context for each of the above to you and asked to
prepare notes against each of the above points.

i) Recently market neutral strategy is recent development in investment strategy domain

with the success of this strategy by hedge funds (though in slightly different format).
The note should cover following items.

a) Overview of Market neutral strategies (4)

b) Suitable example of market neutral strategy (4)

c) any of its limitations, additional considerations. (4)

ii) One of the most recent popular product in high income category has been the recently
launched ETF based on factor style investment strategy and designated as “Alpha smart,
low volatility ETF”. The fund is managed by AMC subsidiary of the group.

The objective of fund is as follows:

“The investment objective of the scheme is to provide returns before expenses that closely
correspond to the total return of the underlying index subject to tracking errors.
However, there can be no assurance or guarantee that the investment objective of the Scheme
would be achieved.”
The note should cover following items.

a) Salient features of multi factor style of investment management (4)

b) Comment on style adopted by the fund manager for this ETF (3)

c) List the benefits of investing in such an ETF (4)

d) AMC has also created an index to be used as benchmark for the performance of this
ETF. Discuss the salient features of index suitable for ETF (4)
Page 2 of 5
IAI SA7-0321

The Government is concerned about low penetration of life insurance savings products and has
conducted a market research to determine the needs of the low income segment which
constitute major chunk of the population. Market research has determined that the following
product attributes of savings products will make the product attractive to the low earner
segment.

 Protection of capital and growth of the purchasing power of their investments

 Accessibility of savings i.e. accessibility to funds when required
 Products that are easy to understand

The regulator has mandated each insurance company to develop non-linked products covering
the above objectives/features for low income category.

The note should cover following items.

iii) Benefits and limitations of using above attributes to construct the investment portfolio
pertaining to the said product. (5)

iv) Passive investment strategy for this product range covering the following items

a) Overview of passive investment strategy (3)

b) Availability of passive vehicles for investment (1.5)

c) Choosing a tracking index (1.5)

d) Choosing “Smart passive” strategy (2)

v) The AMC arm has indicated its willingness to align its interest with those of the life
company when negotiating the structure of fees on the mandates related to the new
products.

The note should cover the following:

How the features of the fee structure might be designed in order to align the interests of both
parties, noting any potential drawbacks to these design features. (5)
[45]

Q. 2)
i) In reference to (Investment) regulations-2016 published by IRDAI, list the instruments /
assets under the following categories:

a) Money market instruments (1.5)

b) Approved Investments (3)

c) Deemed as Approved instruments (2.5)

ii) “Inter creditor agreement is an important step in IBC (Insolvency and bankruptcy code)
framework but only allows RBI regulated lenders to be part of it.” Please comment on the
major shortcoming of this and what steps should be taken to make this a robust framework. (3)

iii) Recently SEBI has approved the proposal to create a ‘side pocket’ for mutual funds.

Page 3 of 5
IAI SA7-0321

a) Explain what is meant by “Side Pocketing”. (2)

b) What are the advantages of side pocketing? (2)

c) Explain the general functioning of this process. (3)

d) Identify the potential misuse of this provision and how these can be minimised. (3)
[20]

Q. 3) You are a new investor to the stock market. You meet a friend who runs a portfolio
management service. Following are the notes you have made from the meeting

 He tells you that his fund has provided 35% return in the last 3 months whereas the
benchmark LOFTY produced only 25% returns.

 His fund has a Sharpe ratio of 1.7 and Beta of 0.7.

 He has a simple algorithm which spots stocks that have risen consistently over the
past five years, and whose current PE is less than historical PE.

 He sets the target for such stocks and sells them once the desired return is achieved.

 Fees at 1.5% p.a of the portfolio with a hurdle rate of 15%. Above the hurdle rate
20% is charged as the profit share.

i) Explain Sharpe ratio and Beta in the context of this fund. (2)

ii) Why are they important ratio’s in portfolio management? (2)

iii) Give 3 Key limitation of Sharpe ratio in this case? (3)

iv) What are the key questions you must ask your friend about the fund performance? (2)

v) Why is PE of a stock considered an important metric to evaluate a stock? (2)

vi) What are the limitations of the above mentioned algorithm? Suggest a key non-financial
additional metric that the fund can measure. (4)

vii) Comment on the fee structure & hurdle rate with a suitable benchmark in the Indian
financial industry. (2)
[17]

Q. 4) You are a fund manager of a large Life Insurance company. 65% of your portfolio is currently
in Govt. securities, 15% in equity and 20% money market instrument.

Your CEO sends you a report which states that in recent budget there will be a “bad” bank
created under which, all PSU banks will package a large portfolio of their non-performing
corporate loans plus good quality residential mortgages, securitise it and sell it funds (such as
your own) offering yields above Government bonds.

The CEO has found out more that this portion of “residential mortgages” are of good quality.
He also believes that if the recovery process is strengthened, then the recovery of corporate
loans will also be decent. He believes there is a big margin being provided which can enhance

Page 4 of 5
IAI SA7-0321
the returns. He has suggested that to enhance your portfolio returns it would be good to
subscribe 10% of the fund into this to get better returns.

i) Describe how assets-backed securities are typically structured. (3)

ii) Indicate to the CEO your main concerns about such an investment and the principal risk
for you as an investor. (7)

Given the COVID situation in India, there has been news that the Government may introduce
policies to stimulate the economy and abandon previous controls on inflation. With Gold price
picking up and rising demand for commodities, the company is considering investment into
Gold market and also commodities.

iii) Define hyperinflation and indicate how the performance of the Commodity and Gold
market could be expected to change during a period of hyperinflation. (2)

Your CEO has read that many major economies have resorted to Quantitative easing by the
central banks. There have been several debates on the quantitative easing. Explain to him the
following:

iv) How Quantitative Easing operates? (2)

v) Explain the impact, including the secondary effects, that Quantitative Easing is likely to
have on the:

a) bond market. (2)

b) equity market. (2)

[18]

********************

Page 5 of 5
 Institute of Actuaries of India

Subject SA7-Investment and Finance

March 2021 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates.
The solutions given are only indicative. It is realized that there could be other points as valid
answers and examiner have given credit for any alternative approach or interpretation which
they consider to be reasonable.
 IAI SA7-0321
Solution 1:
i) a) Market Neutral strategy
 Today, many investors remain reluctant to invest in stocks given market uncertainty.
 While bonds offer an alternative, their values may start to decline if interest rates
begin to rise.
 Market neutral strategies provide another viable option. These portfolios combine
offsetting long/short positions, seeking to offer consistent positive returns whether
markets rise or fall.

 Positive return potential in any market environment

 Market neutral strategies and other absolute return investments pursue positive
returns no matter what happens to the economy, interest rates or financial markets.

 This approach to capturing non-correlated performance has the potential to:

 increase returns for the investor
 reduce the risk for the given level of expected return
 and expand diversification when added to a portfolio of traditional assets.

 Professionally managed market neutral portfolios implement short and long positions in
an effort to eliminate market risk exposure.

 This can produce positive returns independent of the broad market if the portfolio’s long
positions outperform its short positions.
 For example, returns would be positive in rising markets if longs rise more than
shorts.
 In declining markets, returns would be positive if longs fall less than shorts

 The return difference between long and short holdings is known as the “spread,” and a
market neutral strategy’s total return is created by this spread plus any interest earned
from cash holdings.

 Consequently, a portfolio that combines equal long and short positions relies purely on
manager stock selection skill to generate returns.
[4]

b) One of the most common market neutral strategies involves investing equal dollars in
long (buy) and short (sell) positions.

 In a typical market neutral portfolio, the goal is for total returns to exceed prevailing
money market rates by anywhere from 2% to 5%.

 Compared to long-only stock investing, these strategies have the potential to generate
relatively attractive returns with significantly less volatility, since they can benefit from
both rising and declining stock positions.

 Generally speaking, market neutral strategies include three sources of return: the actively
managed long and short positions and the cash component.

 The long portfolio houses the manager’s best “buy” decisions.

 These are attractive stocks the manager believes will appreciate in value over time.
 As such, the long portfolio realizes positive results when its stocks rise in value and
negative results when prices decline.

 The short portfolio contains stocks the manager considers unattractive or trading at
higher prices than their true worth.

Page 2 of 15
 IAI SA7-0321
 To capitalize on these likely underperformers, the manager borrows stocks, sells
them immediately and invests the proceeds in cash.
 If a shorted stock declines in value, the manager can buy it back for less than the
original sales price, thus earning a profit when borrowed shares are returned to the
lender.
 Conversely, if a shorted stock rises in value, the manager pays a higher price and
suffers a loss.

 The cash component is funded primarily with the proceeds from short sales.
 It is invested in Treasury bills or other cash equivalents earning prevailing interest
rates.
 It also serves as the margin account for the short portfolio.
[4]

c) Skilled stock selection is key

 When a portfolio combines equal long and short positions, stock selection becomes the
driving force behind performance.
 Success depends on selecting longs likely to appreciate more rapidly in rising markets
and shorts likely to decline faster in falling markets.
 As a result, market neutral managers rely heavily on an intensive research effort to
gather insights into stocks and generate sound investment ideas.
 In a falling market, for example, strong stock selection should help limit losses from
long positions, while maximizing gains from short positions to earn a positive net
spread.

 Using long buys and short sells to take offsetting positions in a specific sector or industry
is known as “hedging.”
 For example, a manager may hedge exposure to the health care sector by purchasing
(long) health care stocks expected to perform well and selling (short) health care
stocks expected to perform poorly.
 This strategy seeks to reduce overall portfolio risk and enhance return potential by
neutralizing exposure to broad market movements, which are also known as “beta.”

 In a market neutral strategy, the manager needs to maintain zero beta exposure to the
overall market to avoid introducing any added risk or volatility into the portfolio.
 Market neutral strategies often also seek to maintain dollar and sector neutrality as
part of a disciplined portfolio implementation process.
 The net spread between long and short performance drives returns when the
strategy is truly market neutral and directly reflects the manager’s stock-picking skills

 The strategy call for a very high degree of sophistication and knowledge which itself is so
expensive that unless the fund the a huge one, it can neutralise any excess returns; partly
due to costly information and partly due to high remuneration of active fund manager.
[4]

ii) a) Traditionally, most stock portfolios were constructed using one style (or factor such as
value, growth, momentum and volatility).
 These portfolio typically underperform when the underlying premise does not fit
prevailing market conditions.
 Multi factor portfolios aims to address this problem by employing more than one factor
to select stocks for the portfolio.
 This strategy addresses high sector concentration of single factor based index strategies
through diversification of factor-risk exposures and exhibiting lower performance swings.
 Through this approach, an investor gets access to smart beta strategy which is rule-based
and cost-effective.

Some example of multi factor portfolios /index are

Page 3 of 15
 IAI SA7-0321
 NIFTY Alpha Low-Volatility 30 = 50% alpha + 50% low volatility.
 NIFTY Quality Low-Volatility 30 = 50% quality + 50% low volatility
 NIFTY Alpha Quality Low-Volatility 30 = 1/3 Alpha + 1/3 Quality + 1/3 Low Vol.
 NIFTY Alpha Quality Value Low-Volatility 30 = 25% Alpha + 25% Quality + 25% Value
+ 25%Low Volatility.
[4]
b)
The ETF under consideration here is typical example of example (ii) given above
 Stocks with high quality ( represented by Jensen’s Alpha, returns over what
markets/indices deliver) and Stocks with low standard deviation (measure of volatility)
are selected using a rule-driven process.
 This is a passive scheme based on certain rules.
 The strategy does not take into account the valuations of the stocks, which are high
currently.
 Most smart beta ETFs in India suffer from low liquidity on the stock exchanges.
 Also, smart-beta funds are yet to develop a long track record. Therefore, it may be hard
to assess how such schemes would perform across market cycles.
 These funds need to develop a record of delivering across cycles and adequate liquidity
need to be made available for these ETFs ( which may lower the return).
[3]

c) ETFs are generally passively managed mutual fund schemes tracking a benchmark index
and reflect the performance of that index.
 Tracks an index- Index is based on research and back tested data with periodic
rebalancing
 Similar to Open ended mutual fund scheme
 but with Lower expense ratio compared to actively managed schemes
 and lower turnover and higher transparency as compared to actively managed
schemes
 Intraday trading on the exchange - Adequate liquidity with AMC & on stock exchange
 Real time prices
 Provides diversification benefits
 Put limit orders
 Minimum trading lot -1 unit on the exchange
 Mandatory delivery into your Demat account
[4]
d) Salient features of benchmark index
 Universe – Selection of universe of stocks from liquid indices e.g. NIFTY 100 & NIFTY
Midcap 50
 No. Of Constituents – 30 to 100 stocks selected from liquid indices
 Weight – suitable weightage between high quality stocks and low volatility stocks ( e.g.
50%:50%) as per mandate for Beta.
 Stock Cap – Suitable cap across individual stock/Industry/Sector/economy ( say 5% for
individual stock)
 Rebalancing – Annual or semi annual. Too frequent will not be cost effective and less
frequent may left the portfolio with significant risk
[4]

iii) Portfolio construction challenges

Each of these criteria is difficult to achieve in isolation
Protection of capital and growth of the purchasing power of investments
 Insurance policies carry a heavy load of costs
 Capital charges; intermediary commissions; shareholder loadings; administration
expenses; asset management fees.
 This makes it difficult to guarantee no loss on capital cost-effectively
 or to produce attractive rates of return in excess of inflation

Page 4 of 15
IAI SA7-0321
 The problem is exacerbated in the current environment of historically low interest rates,
which makes the pricing of protection structures expensive
 The only asset class guaranteed to keep pace with inflation (if held to maturity) is index
linked bonds
 And demand has driven real yields so low (well below 5%) that the returns may be barely
enough to cover just the expenses

Client access to funds

 Apart from the constraints of insurance legislation it is difficult to structure products with
an attractive value proposition if the term of the investment is unknown at the outset
 This imposes a liquidity constraint that would preclude a wide range of asset classes (even
ignoring the clients’ risk appetite)

Product ease of explanation

 This market segment is not financially sophisticated
 This does not mean that products cannot be financially complex in generating the
outcome to the client
o But from the client’s perspective the product promise will have to be very simple to
explain or there is a high risk of mis-selling
 So any complexity that increases the risk to clients should be avoided
 E.g. this would include passing the risk of the investment return from an absolute return
type fund - where the probability of not meeting the target of inflation-plus returns over
the product life is not insignificant – onto the client

It is even more difficult to achieve the criteria in combination

Returns vs. Access

 Providing clients with access to their funds limits the investment strategies available
 Growth assets are inherently volatile and would be inappropriate as a strategy if
returns are guaranteed over short terms
 But defensive assets are unlikely to deliver required returns after expenses
 Even defensive assets like longer dated bonds may be unsuitable
 Protection structures are usually designed to pay off only after a specified term

Returns vs. Ease of understanding

 Returns can only be augmented by taking on risks such as market volatility or credit
 risks
 But most investment risks are unlikely to be well understood by the clients
 Clients’ demand for simple products can be met by giving guarantees
 If these are underwritten by the insurer it increases capital requirements and hence
costs
 If underwritten by a bank there will be dilution of return to cover bank’s margins and
the introduction of credit exposure to the bank (albeit small)

Accessibility of funds vs. Ease of understanding

 To create products that allow clients to access their savings more easily the product will
have to
 ... invest very conservatively
 ... or apply surrender conditions
 In the first instance clients who do not access their funds may be disappointed with the
meagre returns generated from near-cash portfolios
 In the second instance clients who are unaware of market dynamics will not understand
why their money has diminished in value when they withdraw their savings
[5]

Page 5 of 15
 IAI SA7-0321
iv) a) Passive investment strategies
Philosophical basis of passive investment
 The primary motivation for using passive strategies seems to be to minimise costs
 This pre-supposes that active management does not add more value by alpha
generation than it detracts through costs
 This is still a hotly debated topic in the equity market context
 It seems that through market cycles active and passive strategies alternate in
effectiveness
 This is largely driven by varying levels of volatility (because high volatility
 causes all shares to move in unison negating stock picking advantage)
 ... and the success or otherwise of large cap shares (because indices tend to have a
higher weighting of them)
 Active bond managers appear to be able to outperform passive strategies more
consistently
 ... but the scope for outperformance is more limited
 ... and this may be purely a function of using sovereign debt fund, which only contains
government and quasi-government bonds, as a benchmark as opposed to something
more appropriate
 And the fees are lower than for equities so the savings are also less
 Another consideration is the product’s sensitivity to downside
 It is often argued that passive management guarantees a return less than the index
(after costs) while active management has the potential to outperform the index
after fees, if the right manager was chosen
 But active management also creates the potential to underperform the index –
possibly by a large margin, especially net of fees
 If this outcome (perhaps at a time when markets are also falling) is very detrimental
to the product, putting a cap of the downside relative to the index could be an
attractive feature
[3]

b) Availability of passive vehicles

 Vehicles are not available for all asset classes or strategies
 In India it is easiest to track equity indices - via ETFs and passive mutual funds
 ...but equities may only be a small part of these portfolios
 The cheapest indices to track (such as the NIFTY50) may also have the least appropriate
risk profile
 Vehicles to track the more desirable indices may not be available
 ... in which case the costs of creating them might negate the anticipated savings
 ... or they might be subject to higher tracking errors because replication is
problematic
 However, the choice of vehicles is widening as the range of ETFs and passive mutual funds
is steadily growing
[1.5]
c) Which index to track
 Passive investment locks the returns onto that of the index being tracked, with minor
variations for costs and errors of matching
 But choosing the index is likely to have a far more decisive effect on the investment
outcome than the difference between the returns of the index and the average active
 manager
 Much recent research has concentrated on the inefficiency of cap-weighted indices
 So finding a more efficient index, and especially one with desirable risk characteristics,
would be highly beneficial and probably more than compensate for any lost alpha
 E.g. an ETF based on high dividend paying shares might have a desirable “value” profile
rather than the VIX
[1.5]

Page 6 of 15
 IAI SA7-0321
d) “Smart passive”
 There is a developing range of semi-passive products called “smart passive” funds - quasi-
indexed portfolios with actively chosen sector or style tilts or biases in an attempt to add
outperformance or improve the risk characteristics of the portfolio
 By specifying a lower tracking error and deploying a lower risk budget the risks of
underperformance are reduced
 They could be useful in providing reasonably low cost portfolios that have appropriate
risk/return characteristics to suit the savings products
 The use of these, and any non-vanilla passive funds, does imply that research on the
vehicles and the asset managers will be required – with the associated costs
[2]

v) Aligning interests on fees

 A common structure of fees is
 ... for the asset manager to charge a fixed base fee in percentage terms
 ... with a performance fee paid if a hurdle rate is surpassed
 The choice of hurdle rate is critical to ensure that the manager is only rewarded for alpha
added
 This goes some way to aligning interests because the manager benefits most when it
produces superior returns for the client
 But the balance still favours the asset manager
 ... because the base fee is seldom more than 10 basis points less than the fixed only
fee whereas the performance fee is usually capped at much higher levels, like 100bps
in total across all components
 The asymmetry in benefit can be illustrated by postulating an unethical manager using
this structure and managing half its clients with one extreme market view and the other
half with a diametrically opposite view
 The manager will earn the fixed fee on all clients and quite possibly the full
performance fee on the half that benefited by actual market conditions
 If the fee basis was 50bps + 20% capped at 100bps the manager will earn 75bps on
the total portfolio (50bps on one half and 100 bps on the other) without requiring
any skill
 A manager may also be tempted to take excessive risks in order to earn the performance-
based fee

To more fully align interests, the fee structure might

 Include more severe penalties for underperformance such that the asset manager only
covers costs or even incurs losses
 This would probably only be feasible within a group - where the ultimate good of the
shareholders of the group takes precedence over the earnings of the individual
entities within the group
 Include claw-back clauses that allow for past performance fees to be refunded if later
performance flags
 To ensure that transitory performance is not rewarded and
 ... the performance fee does not in effect give a free annual call option to the asset
manager
 Adopt the strategy of a “high-water mark” commonly used in hedge funds
 This ensures that future outperformance is not rewarded until past
underperformance is made good
 Again this should work well with an in-house manager which will have to answer to
the group board and cannot cancel the mandate if it gets too far “under water”
 Monitoring and calculating these watermarks and claw-backs can get very complex [5]
[45 Marks]

Solution 2:

Page 7 of 15
 IAI SA7-0321
i) a) Money Market Instruments shall comprise of Short term investments with maturity not
more than one year comprising of the following instruments:
 Certificate of deposit rated by a credit rating agency registered under SEBI (Credit Rating
Agencies) Regulations, 1999
 Commercial paper rated by a credit rating agency registered under SEBI (Credit Rating
Agencies) Regulations, 1999
 Reverse Repo
 Treasury Bills (including Cash Management Bills)
 Call, Notice, Term Money
 CBLO as per Schedules I and II of these Regulations.
 Any other instrument as may be prescribed by the Authority
[1.5]

b) Approved Assets
 debentures secured by a first charge on any immoveable property plant or equipment of
any company which has paid interest in full
 debentures secured by a first charge on any immovable property, plant or equipment of
any company where either the book value or the market value, whichever is less, of such
property, plant or equipment is more than three times the value of such debentures
 first debentures secured by a floating charge on all its assets of any company which has
paid dividends on its equity shares
 preference shares of any company which has paid dividends on its equity shares for at
least two consecutive years immediately preceding
 equity shares of any listed company on which not less than ten percent dividends have
been paid for at least two consecutive years immediately preceding
 immovable property situated in India, provided that the property is free of all
encumbrances;
 loans on policies of life insurance within their surrender values issued by him or by an
insurer whose business he has
 acquired and in respect of which business he has assumed liability;
 Fixed Deposits with banks) and;
 such other investments as the Authority may, by notification in the Official Gazette,
declare to be Approved Investments.
[3]

c) Deemed Approved Assets

 All rated debentures (including bonds) and other rated & secured debt instruments.
Equity shares, preference shares and debt instruments issued by All India Financial
Institutions recognized as such by Reserve Bank of India
 Bonds or debentures issued by companies, rated not less than AA or its equivalent and
A1 or equivalent ratings for short term bonds, debentures, certificate of deposits and
commercial papers by a credit rating agency
 insurer’s deposits [including fixed with banks (e.g. in current account, call deposits, notice
deposits, certificate of deposits etc.) and deposits with primary dealers duly recognized
by RBI
 Collateralized Borrowing & Lending Obligations (CBLO) created by the Clearing
Corporation of India Ltd and recognized by the RBI and exposure to Gilt, G Sec and liquid
mutual fund forming part of Approved Investments as per Mutual Fund Guidelines
 Asset Backed Securities with underlying Housing loans or having infrastructure assets as
underlying as defined under ‘infrastructure facility’
 Commercial papers issued by All India Financial Institutions recognized RBU and having a
credit rating of A1 by a credit rating agency
 Money Market instruments
[2.5]

Page 8 of 15
 IAI SA7-0321
ii) Currently only RBI regulated lenders and mandates them to enter into ICA. Non- RBI
regulated lenders like Mutual funds and insurance companies are not governed by it and thus
may not cooperate may not lead to early resolution on stressed assets. Mutual funds and
insurance companies are often the largest institutional investors and ICA without these
entities may focus on recovery / interest of RBI regulated entities and thus prejudice the
interest of millions of small investors show have invested through mutual funds and insurance
companies. Thus, current ICA rules are not aligned in principle of equitable treatment of all
the creditors. RBI, SEBI and IRDAI should potentially come up with amended regulations wider
participation of wider stakeholder base to incorporate the interests of all the stakeholders.
[3]

iii) a) Side Pocketing

 ‘Side pocket’ allows managers of debt funds to segregate illiquid and distressed assets
from other relatively liquid assets in a fund’s portfolio.
 Such illiquid assets may include investments in bonds that are scarcely traded,
commercial papers of companies in default, etc.
 In case of mutual funds, a side pocket creates a separate portfolio for illiquid, risky or
stressed securities so that these do not affect other liquid assets of the scheme in case of
a “credit event”.
 In simple terms, a ‘credit event’ is defined as a sudden, usually negative, change in a
borrower’s capacity to pay their loan obligations. Example of a credit event include
bankruptcy, debt restructuring and default on payments.
[2]
b) Advantage:

 Any debt mutual fund with significant stake in a company that is defaulted, is allowed to
make use of the side-pocketing mechanism. This is because the default of one company
may lead multiple investors to redeem their money from the scheme in order to avoid
additional losses. The fund house will then be forced to sell its good quality papers in
order to pay the investors redeeming their investments.
 Further, in a situation of crisis, generally, institutional investors have the first right to
redemption. This process leads to retail investors getting stuck in segregated or toxic
assets. This will further increase the quantity of bad assets in the portfolio leading to a
further decline in the value of the fund.
 In such a scenario, it is better for the fund house to segregate its stressed investments
and take a one-time loss on the fund’s investment so that more and more investors do
not rush to redeem their investments as the value of the fund decreases.
 Thus, implementing side-pocketing in such a scenario helps fund houses manage
redemption pressures better given the fact that other holdings are not be impacted.
 Further, the units (in the segregated portfolio) have to be listed on a stock exchange
within X ( 10 day) days to facilitate exit of the unit holders. Effectively, this makes the
price discovery of the bad assets with investors having the freedom of either selling it at
prevailing price or holding it if they expect the value to recover in future
 Side pocketing also ensures that investors who were in the investment at the time of
write-off, will get a benefit if there is any recovery from the bond.
 The process of side pocketing ensures liquidity is not choked for investors holding the
units of the primary scheme as allotment and redemption are done on liquid assets.
[2]
c) How it works:
 Side-pocketing enables the mutual fund schemes to split the Net Asset Value (NAV) into
two parts.
 One NAV is for the liquid assets of the scheme and the other is for the side-pocketed
illiquid ones. This ensures that the side-pocket does not adversely impact the liquidity
and the valuation of the good quality assets held in the portfolio.
 Doing so ensures that if a security is downgraded to ‘junk’ or ‘default’ status in the side-
pocket, the change will be restricted and would not end up affecting the entire scheme.
Page 9 of 15
 IAI SA7-0321
 Once the segregation of investment is done, segregated or toxic investments will be
closed for future subscription. However, investors can continue to subscribe to the
portion that comprises of liquid assets or safer assets.
 Once a side pocket is created, it is split off of the rest of the scheme and closed for
subscription as well as redemption.
 Investors can, however, continue to invest and/or redeem their investments in the non-
side pocketed portion of the schemes. In case, the fund house receives any money from
the side-pocketed funds in the future, it will pay the amount back to the unitholders of
the side-pocket.
 All existing investors in the scheme are allotted equal number of units in the segregated
portfolio as held in the main portfolio and no redemption or subscription is allowed in
the segregated portfolio. Thereafter, the units (in the segregated portfolio) have to be
listed on a stock exchange within X ( 10 day) days to facilitate exit of the unit holders.
[3]
d) Limitations and mitigation

 Side pocketing is a process that should be used cautiously. Also, valuation of illiquid
investments is contentious. Thus, the NAV of the illiquid asset will remain a [Link],
two NAVs – one each of liquid asset and the illiquid asset will be difficult to track for
investors.
 This provision could be misused by MFs to hide their bad investment decisions or take
more more credit risky assets in portfolio to enhance the return.
 Trustees of all fund houses will have to put in place a framework that would negatively
impact the performance incentives of fund managers, chief investment officers (CIOs),
etc. involved in the investment process of securities under the segregated portfolio.
 The mutual funds must decide on the creation of a segregated portfolio on the day of a
credit event, and the trustee approval is required to be taken within one working day of
this.
 The SEBI has also stated that side pocket should not be looked upon as a sign of
encouraging undue credit risks as any misuse of the option would be considered serious
and stringent action can be taken.
 Any debt mutual fund with a corpus of Rs.1000 crore and at least 5% exposure to a
company that is defaulted, is allowed to make use of the side-pocketing mechanism.
 An AMC (Asset Management Company) must propose to create a side pocket by
amending the existing SID (Scheme Information Document) of the fund and allow an exit
window of 30 days to the investors without charging an exit load.
[3]
[20 Marks]

Solution 3:
i)  Sharpe ratio is the measure of risk-adjusted return of a financial portfolio. [1/2]
 A portfolio with a higher Sharpe ratio is considered superior relative to its peers [1/2]

 If the value of the Sharpe Ratio is 1.7, it essentially means that the fund has
delivered 1.7% more returns than that from a risk-free financial asset.

 Beta denotes the sensitivity of the fund towards market movements. [1/2]
 It is the measure of the volatility of the fund portfolio to the market. [1/2]
Beta of 0.7, implies the fund is less volatile than the market. [1/2]
[Max 2]

Page 10 of 15
 IAI SA7-0321
ii) Sharpe ratio is very useful when investor has to compare returns between various funds.
Higher ratio represents higher returns for every unit of risk [1]

Beta is very important when it comes to managing a portfolio. Different stocks in a portfolio
have different betas and the portfolio manager will try to arrive at a target beta for the
portfolio by adding or deleting certain stocks from the portfolio. low-beta of a portfolio pose
less risk but also lower returns. High beta stocks go up more than the index when the markets
are bullish and go down more than the market index when the markets are bearish. [1]

[2]
iii)  Sharpe Ratio doesn’t give any information on whether the equity investment is
skewed towards a particular sector or not. As is the case here, the risk on investment
is quite high, which the Sharpe ratio of the fund might not reflect.
 Another notable drawback of Sharpe ratio is that it cannot distinguish between
upside and downside and focuses on volatility but not its direction.
 Sharpe ratios is backwards-looking and accounts for historical returns and volatility.
The decisions based on the ratio assume future performance will be similar to the
past
 The calculation of Sharpe ratio based on the assumption that returns are normally
distributed, but in real market scenarios, the distribution might have fatter tails,
which decreases the relevance of its use
Any 3 [3]
iv) Key questions to be asked

1. Returns over at least past 3 years instead of just 3 months?

2. Is it not a very easy algorithm that can be copied?
3. What is the definition of PE? Is it based on past earnings or future earning?
4. Does this algorithm lead to churning?
5. What’s the expense incurred?
6. Is LOFTY the right benchmark for this portfolio?
7. What is the desired return at which he sells?
Any 4 [2]

v) PE of a stock = Price of the stock / Earning per share

 PE multiple is generally used by analysts and investors for evaluating the relative
performance of the stock with respect to its peer.
 This ratio tells the amount we investors have to invest to receive a unit of the
company’s earnings.
 It is a very important multiple for a relative valuation of a stock.
 This ratio conveys very important information of stock value – whether they are
undervalued, overvalued or fairly valued.
 Hence, for a stock, we investors can map whether it is a good time to buy an under
priced stock or sell an overpriced stock.
 This benchmark PE is the industry median PE for a stock.
 Every industry has a benchmark PE for reference which is then used to gauge the
share price of the stock
[1/2 mark for each point]
[2]

Page 11 of 15
 IAI SA7-0321
vi) Limitations to the algorithm

 The algorithm is based on PE ratio only.

 The first part of the P/E equation or price is straightforward as the current market
price of the stock is easily obtained. But, determining an appropriate earnings
definitions and number can be more difficult.
 Volatile market prices, which can throw off the P/E ratio in the short term.
 The P/E is typically calculated by measuring historical earnings or trailing earnings.
Unfortunately, historical earnings are not of much use to investors because they
reveal little about future earnings, which is what investors are most interested
in determining.
 Forward earnings or future earnings are based on the opinions of analysts.
 Analysts can be overoptimistic in their assumptions during periods of economic
expansion and overly pessimistic during times of economic contraction.
 One-time adjustments such as the sale of a subsidiary could inflate earnings in the
short term. This complicates the predictions of future earnings since the influx of cash
from the sale would not be a sustainable contributor to earnings in the long term.
 Although forward earnings can be useful, they are prone to inaccuracies.
 Earnings growth is not included in the P/E ratio.
 The biggest limitation to the P/E ratio is that it tells investors little about the
company's EPS growth prospects.
 If the company is growing quickly, an investor might be comfortable buying it at a
high P/E ratio expecting earnings growth to bring the P/E back down to a lower level.
 If earnings are not growing quickly enough, an investor might look elsewhere for a
stock with a lower P/E.
 In short, it is difficult to tell if a high P/E multiple is the result of expected growth or
if the stock is simply overvalued. [1/2 mark for each point]
[Max 3.5]
Non-Financial metric

 Management of the company. [1/2]

Any other suitable example [Max 4]

vii) Fee Structure

 Fee structure suggested is pretty standard where in upfront a fee is charged. Also,
once the hurdle rate is met profit share arrangement is also pretty standard.
 1.5% - 2.5% is standard in the market
 The hurdle rate here seems to be very low. For PMS typically the hurdle is 25% above
which a profit share is charged
 The benchmark for the fee is Mutual fund industry where 2.5% is the charged for
equity funds.
[1/2 mark for each point]
[Max 2]
[17 Marks]

Solution 4:
i) Asset Back Security

 Most asset-backed securities are structured using a “pass through” security whereby
the retail bank creates a portfolio into which the loans from the retail bank are
transferred.
 This can then be securitised and sold to investors.
 The payments of interest and capital from this security to investors are normally
guaranteed by an institution so that the credit risk is removed.
Page 12 of 15
 IAI SA7-0321
 The responsibility for collection of payments on the debt normally remains with the
issuing retail bank.
 The retail bank may take a certain proportion of the income from the payments
in order to cover its costs.
 The default risk may or may not be passed to the investors [3]

ii) Default Risk

How can one be certain about the quality of loans backing this?
Is there any reports / evidence that can be studied?
In the event of default by the retail bank’s customers, what happens to the payments?
Is there a guarantor?
Is there a risk of default by the retail bank itself?

Prepayment Risk

As the loans backing are mortgages, there is a risk of prepayment which means that the term
of the debt will not be known.

Mortgages are repayable at any time by the bank’s customers. If they repay, what happens
to the investment?

Mismatch of Duration

This investment is a medium-term fixed interest investment that will provide a suitable
match for the fixed liabilities of the institution

The institution has a risk with respect to the interest rate charged to mortgage customers.
If the rate falls due to competitive pressures or due to the level of short-term interest
rates, the yield on the investment will fall

Liquidity Risk

Liquidity may also be a concern for the institution, as it will require a certain amount of
cashflow to meet claims and expenses.
It is not given if the company is expanding or contracting.
If the company is expanding it may be short of cash because of new business expenses on
setting up the new policies.
If it is contracting it will perhaps be paying out more in claims than it received as premiums.
The need for regular income from the investment will be determined by such factors
Additional Spread

Is the additional spread sufficient to cover the additional risk being undertaken?

Marketability of this assets is a concern

Are there any regulatory norms that are to be checked?

Transaction Cost

The transaction costs of such a deal would be a concern. It is complex and requires a
complicated legal framework to make it work

Tax

Tax may be a concern to the institution. The tax efficiency of this security would need to
be carefully examined.

[1/2] mark for each point

[7]

iii) Hyperinflation
Page 13 of 15
 IAI SA7-0321
In economics, hyperinflation is inflation that is very high or “out of control”, a condition in
which prices increase rapidly as a currency loses its value. [1/2]
It is likely to be associated with near economic collapse. [1/2]

Gold – likely to be positive

In theory gold is likely to rise in price in line with general inflation as it should maintain its real
value. Gold may increasingly be used as a store of wealth increasingly its functional use. [1]

Commodities - negatively
Is likely to maintain its real value offset to the extent its functional value will fall due to lower
demand. Shutting down of industries etc may have an adverse impact on the investments.
[1]

[Max 2]

iv)  Quantitative Easing (QE) is a monetary policy used by some central banks to
increase the supply of money.
 It usually involves both a direct increase in the money supply and a indirect effect from
the reserves,
 QE is usually implemented by a central bank by first crediting its own account with
money.
 It then purchases financial assets, for example government bonds, agency debt,
mortgage-backed securities and corporate bonds, from banks and other financial
institutions in a process referred to as open market operations.
 Buying these securities adds new money to the economy, and also serves to lower
interest rates by bidding up fixed-income securities. It also expands the central bank's
balance sheet
[2]

v) a) Impact on Bond Market

QE will likely directly impact the bond market due to the purchasing of bonds by the central
bank – driving up prices and driving down yields. [1/2]
Speculation by market participants is likely to exacerbate this impact as speculators try to
front-run the central bank. [1/2]
Those who sell government bonds to the central bank will likely want to purchase other bonds
in their place. [1/2]
Central banks, such as the ECB and BOJ have begun to also directly purchase non-government
bonds, meaning that there will also be a direct impact on those markets. [1/2]

Secondary impacts
The secondary impact will be that more corporate bonds are issued to take advantage of the
lower yields and lower financing costs. [1/2]
This may moderate the increase in prices and decrease in yields in the bond markets. [1/2]
In the longer-term the additional issuance could lead to higher inflation due to increased
economic activity. [1/2]
[Max 2]

b) Impact on Equity Market

Those who sell their assets to the central banks, e.g. their bonds or corporate bonds, will
receive cash. [1/2]
Due to low yields they will typically want to invest the cash in equities and other higher
yielding assets. [1/2]
This is likely to be result in rising prices for equities and other risky assets. [1/2]

Secondary impacts
Page 14 of 15
IAI SA7-0321
Companies are likely to use the lower bond yields to issue more bonds for share buybacks.
[1/2]
Companies may also refinance existing debt at lower yields.
[1/2]
This is likely to lead to increased growth prospects and increased corporate profitability due
to lower financing costs. [1/2]
[Max 2]
[18 Marks]
***************************

Page 15 of 15
 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

19th November 2020

Subject SA7 – Investment and Finance

Time allowed: 3 Hours 30 Minutes (14.30 - 18.00 Hours)

Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions to examinees sent along with hall ticket carefully and
follow without exception.

2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate should
answer the question with reference to Indian environment.

3. Mark allocations are shown in brackets.

IAI SA7-1120

Q. 1) The National Government has been trying to increase the social benefits to its population,
particularly the retired individual from private sector who does not have access to pension
similar to the one given to Government employees. The Government is keen to introduce
defined contribution pension scheme to be made available to all private sector employees and
new employees joining the Government jobs. As part of regulations introduced by Government,
the fund is being managed by a Board of Trustees. You are a consultant employed by the board
for advising them on the Fund’s investment strategy.

The Trustees have decided to adopt a Lifestage investment strategy. The Lifestage framework
comprises three portfolios with different risk profiles. These portfolios have the following
allocations:

Growth Portfolio Moderate Portfolio Low Risk Portfolio

Equities 65% 45% 20%
Bonds 30% 45% 55%
Cash 5% 10% 25%

Members’ funds are initially invested in the Growth Portfolio. At age 50 they are transferred to
the Moderate Portfolio and at age 55 are transferred to the Low Risk Pre-retirement portfolio.
Retirement age is 60. No further options are made available to members.

i) Discuss the limitations inherent in Lifestage investment strategy and recommend solutions
to these. (10)

One of the Trustees believe that the fund should invest more widely and has proposed to invest
fund in unquoted equities and commodities.

ii) Outline the advantages and disadvantages of investing in each of these new asset classes. (7)

iii) COVID 19 has hit country. The country had to impose several harsh lockdowns. As a result
it is experiencing slow economic growth and relatively high unemployment, which is at the
same time accompanied by rising prices (i.e. inflation).

Discuss the expected impact on the performances of the following assets.

a) Domestic Equities (4)

b) Commodity like Aluminum (3)

The Trustees are considering introducing a default annuity option for members retiring from
the Fund.

iv) Briefly describe and list the advantages and disadvantages of the following options:

a) Fixed Life annuity (with or without fixed increases) (2)

b) Living annuity (2)

c) Inflation-linked annuity (2)

d) With-Profits annuity (1)

Page 2 of 4
IAI SA7-1120

The Trustees have narrowed their options for the default annuity to either an Inflation-linked
annuity or a With-Profits annuity provided by a reputable insurer.

v) Recommend, with reasons, how the investment strategy for the Pre-Retirement Portfolio
should be changed (if at all) in order to better protect the level of post-retirement income
for each option. (5)

vi) A Trustee has advised that one of the Fund’s investment managers, in a report-back,
showed them a graph of the Indian Volatility Index (VIX). The trustee has asked for more
information on the VIX.

a) Explain what the VIX represents and how the index should be interpreted. (3)

b) Describe the potential uses to an institutional investor of VIX as an indicator, as well as

the derivative instruments based on it. (3)
[42]

Q. 2) Two press articles recently caught your attention.

i) First one talks about a non-professional investor who has made some investments.
Describe the financial behaviors’ exhibited by each of the scenario below.

a) He bought a banking stock 4 months back and it has lost 40% of its value. Market trends
and consensus is that the share price will dip further. (2)

b) He bought a share in a pharma company after reading a report on the vaccine it has
developed and awaiting approval for the trials. No major analyst is confident about the
capability of the pharma company to develop this vaccine and the approvals to come
through. (2)

c) He bought a stock in the travel portal Makemetrip which has risen in value from INR
100 to INR 200 per share over the last two years. Makemetrip was innovative in its
offering but market becoming more competitive and it is likely that Makemetrip may
lose customers. The investor continues to hold the stock as he believes that, based on
past performance and his own research, the share price will double again over the next
two years. (2)

d) He buys a bond with a 5% per annum guaranteed return. The alternative investment he
could have made was in a bond with a 20% probability of a 0% return and an 80% chance
of a return greater than 10% per annum. When discussing the bond investment with his
wife, he states “we can either invest in a bond which will guarantee 5% each year or in
a bond where there is a 20% chance we will not make any money”. (2)

ii) Second article that you read in the press recently has commented “ The investment
regulations are highly prescriptive”

a) List 2 example of investment regulation from the insurance industry which can be
described as prescriptive. (2)

b) Give 2 advantages and 2 disadvantages of such prescriptive regulations? (4)

Page 3 of 4
IAI SA7-1120
c) Explain for a bank what the minimum reserve requirement is and how this differs from
a risk-based capital requirement. (3)

d) Give reasons why a bank regulator may prefer a risk-based capital requirement to a non
risk-based capital measure with a higher level of coverage. (5)
[22]

Q. 3) A life insurance company, Lead Life Pvt Co. ( Lead Life ), is considering buying Aam Bazaar
Pvt, a network of life insurance web aggregator. Lead Life will be paying for Aam Bazaar with
retained cash.

Aam Bazaar earns income through commission on the products it sells. The commission paid
is high in the first year and smaller renewal commission is paid until expiry. Aam Bazaar has a
significant amount of debt on its balance sheet and it has recently made a loss.

Aam Bazaar’s Board of Directors rejected Lead Life’s initial offer and Lead Life has announced
publicly that it is considering whether to make a public offer for the shares of Aam Bazaar, that
is a hostile bid for the company.

i) Suggest reasons for the acquisition and why these reasons are likely to be borne out in
practice. (12)

ii) Describe defensive strategies that Aam Bazaar could employ to prevent the acquisition. (6)

iii) Describe the factors that will affect the share prices of both Lead Life and Aam Bazaar
during the bid period. (4)

Lead Life plans to securitise Aam Bazaar’s commission income once the purchase is
completed.

iv) Describe how the securitization could be structured. (4)

Whilst the process was on, COVID 19 hit the country and Lead Life Co. decides to drop the
bid. Though Aam Bazaar successfully defended the bid but the costs and management
distraction of doing so have resulted in considerable financial strain.

v) List possible management actions that may be taken as a result of Aam Bazaar being in
financial distress. (5)

vi) Outline the possible consequences of these actions. (5)

[36]

*******************

Page 4 of 4
 Institute of Actuaries of India

Subject SA7-Investment and Finance

November 2020 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates.
The solutions given are only indicative. It is realized that there could be other points as valid
answers and examiner have given credit for any alternative approach or interpretation which
they consider to be reasonable.
 IAI SA7-1120
Solution 1:
i) Lifestage Strategy
 The biggest problem with such strategy is to determining the attributes of an
“average” member who may not really exist and trying to fit strategy to all the
members without considering their individual needs like vacations/ home purchase/
childrens education and marriage/ medical needs etc.
o Very few members will actually retire and may access their funds as cash –
offer a cash portfolio as an alternative.
 Certain members may be more or less risk tolerant depending on their particular
investment horizon and personal circumstances.- opportunity may be given to “opt
out” of the Lifestage structure and phasing down process described and either select
one of the risk profile portfolios offered or alternative portfolios could be offered.
 strategy members will take some part of their corpus as cash lumpsum. Tax incentives
may reinforce this behaviour. Re-design a strategy which does offer a pre-retirement
portfolio targeting full annuitisation of capital at retirement. Members could then
“opt-out” their cash lumpsum.
 Focus on preservation of capital and not preservation of income as members
approach retirement.
o Protect the size of annuity that can be purchased rather than the capital
amount at retirement.
o Consider the types of annuities members typically purchase at retirement.
 A fixed annuity would require a matching portfolio of bonds of the
correct duration
 With profit annuity or living annuity would require a more aggressive
approach
o introduce different pre-retirement channels catering more specifically to
popular annuity choices.
o administratively complex but also forces members to consider their situation
and options in good time,
 Too conservative at retirement and de-risking starts too early and is too severe
considering the potential longevity of members who are retiring at 60– potentially a
30 year time horizon for younger member.
 Pre-retirement portfolio may be considered too volatile by some and members may
in fact lose money as they approach retirement.
 This strategy with fixed asset class allocation does not take current market conditions
into account and doesn’t allow managers discretion in asset classes and members
thus loses on extra returns that could have been achieved by actively managing the
funds.
 Funds for a members are mechanically switched and could be selling and buying at
worst possible time when not necessary. This is especially true where we have
volatile asset classes.
 The solution would be to introduce a more gradual phasing in from one portfolio to
the next, Trying to time the markets and make a call on the timing of the moves is
not a recommended solution.
o For example mechanically switching from a higher risk portfolio to a lower
risk portfolio (eg High to Medium risk or Medium to Low risk) could take place
on a specific date or during period where equity markets have experienced a
significant correction.
o These losses are then crystallized as a result of the switch and the member
misses out on the subsequent recovery on this portion of his assets if the
switch had been delayed – often by a relatively short period.
 The administration and management framework required to run a more complex
strategy such as this one,
o Together with more frequent trading associated with the switches between
the Lifestage portfolios could result in increased direct costs being borne by
members.

Page 2 of 9
 IAI SA7-1120
[10]

ii) Unquoted Securities

Advantages:
 Diversification, although if the unquoted companies operate in the similar
industries to quoted companies in which the fund invests there may be less
diversification than first thought.
 Potentially higher returns as the security may be less well researched, leading to
pricing anomalies.
 Unquoted companies are often small and therefore can still grow rapidly even in
relatively mature industries.
Disdavantages:
 The risks will be higher as often the company and the management will have
no track record.
 The investment will be very illiquid and may need to be held for long time.
 It will be difficult to value.
 The company may be more dependent on one person.
 It will require specialist knowledge to invest in this area, this will mean higher
management fees. It is unlikely that the in-house team will possess the necessary
skills, therefore a third party fund manager will need to be employed, thus
increasing costs.
 The companies are likely to be less financially stable and will have less ability
to raise additional capital should the need arise.

Commodities
Advantages:
 Investment in commodities would provide diversification for the pension fund.
 It is possible to make significant profits from investing in commodities in short
periods, however there is also the opportunity to lose large amounts in equally
short periods.
Disadvantages:
 Like investing in unquoted securities, the Trustees will almost certainly need to
employ third party fund managers.
 Use of commodity shares (mining, exploration companies) gives less
diversification from equity market than physical would.
 Institutions do not invest directly in commodities as this would involve shipping
and storage of large amounts of material and institutions do not have the
necessary skills or facilities.
 Commodities do not naturally fit into an asset liability model as they are neither
real assets or fixed rate assets, therefore unless the Trustees can identify an
institution with a very good record in this area there is little to justify investing in
this area.
[7]

iii) a) Domestic Equities

With lockdowns, lot of manufacturing, retail and auto companies would have found it hard
to continue without any business interruptions. This would will hurt the performance of
domestic equities. If Govt announces any measures / initiatives to simulate growth there may
be offset to some degree. Negative sentiments may affect the equity market [2]

Interest rates are unlikely to be lowered because of inflation, and would not act in their usual
counter-cyclical way to help equities during times of poor economic growth. [1]

Page 3 of 9
 IAI SA7-1120
The domestic economy is likely see its currency depreciate. However, higher interest rates
(to combat inflation) may stimulate the flow of money into the economy which help
strengthen the currency.

A depreciating currency will see domestic companies with operations abroad, see the value
of the operating profits of those operations rise in local currency terms and this should
benefit their share prices. [2]

Share prices will also be helped by the rising real value of their assets. [Max 4]

b) Commodities
In theory, the price of commodities like Aluminum should rise in line with general price rises.
It should maintain its real value. [1]

The demand for Aluminum for industrial, and other economic activity related uses, is likely to
fall due to the economic stagnation. [1]

This will likely negatively affect the price of Aluminum and to a greater degree than for gold
as Aluminum is used to a greater extent in industry and manufacturing.

Commodities may benefit from Government related economic stimulus. [2]

However, government sponsored grants and subsidies (if any) may be scaled back due to
likely fiscal problems. [1]
[Max 3]

iv) Annuitisation Options

a) Fixed Life Annuity (with or without fixed increases)
o Member purchases an annuity from insurer. Annuity is guaranteed to be paid for
life of annuitant and may be designed to pay a percentage income to a qualifying
widow/er on death of the annuitant. Annuity amount remains fixed throughout
the life of the annuitant, reducing for the spouse. No annual increases are
awarded.
o On death of spouse no further payment is made
o No longevity risk but significant inflation risk
o Costs associated with writing guaranteed annuity business are high for insurers –
expensive option [2]

b) Living Annuity
o Member invests their Fund credit with a life insurer. Member then draws down
a monthly income from their investment at a level of their choice. Regulation may
limits this to between say 1% and 20% of the capital balance every year.
o Member has a degree of choice around the investment strategy and portfolios
for their fund value.
o Any remaining balance in the account at death is paid to estate/beneficiaries
o Member assumes longevity risk – if funds run out before death he will run out of
money.
o Member assumes investment risk – if asset perform poorly it may affect his level
of income [2]

c) Inflation-linked annuity
o As for level annuity, but annuity amount is guaranteed to increase with
inflation every year
o Therefore removes inflation risk as well as longevity, investment risk
o Due to high level of guarantees offered by the Life Company/issuer, this is
the most expensive type of annuity to secure

Page 4 of 9
 IAI SA7-1120
[2]
d) With Profits annuity
o As for level annuity, but annuity amount will increase every year by an
amount declared by the issuer. This will depend on the performance of the
underlying assets as well as a degree of smoothing.
o Increases are therefore not guaranteed
o Amount of annuity cannot however decrease from one year to the next.
o A popular alternative to a inflation linked annuity as the costs may be lower
due to the lower degree of guarantee offered
Member may still assume some inflation risk – particularly when market conditions are poor

[1]

v) Inflation linked annuity (ILA)

 Pricing of ILA closely linked to (longer dated) inflation linked bonds (ILBs).
 In order to protect the level of income that can be purchased, fund should have a
significant allocation to a portfolio of ILBs
 Consider appropriate duration of the ILB portfolio
 This represent the duration and yield curve sensitivity of the insurer’s ILA underlying
portfolio.
 Hence would need to take care in how to measure the performance of the ILB
portfolio as it may not be represented by a typical index.
 Exposure to ILB’s will also protect the (real) value of capital if ILB yields are not too
volatile – may be more appropriate for the portion intended to be taken in cash at
retirement
 Yields on ILB’s are low, so may want some exposure to growth assets (such as
equities) given the period of time in this portfolio
 With Profit annuities – these policies usually back by a range of assets such as
equities, bonds, ILB’s.
 Risks are pooled and returns are effectively “smoothed” in order to provide a
sustainable predictable level of pension increase
 Pricing of with profit annuities not closely linked to a particular asset class. Prices
usually more static (given the pooling/smoothing)
 A combination of cash, equities and bonds – not unlike what fund has right now –
would be appropriate
 Will still need to protect the capital for a portion of the assets intended to be taken
as cash at retirement
[5]

vi) Volatility Index

a) VIX is index based on implied volatilities of options and it is forward looking
o i.e. it incorporates investors’ assumptions about future volatility
o Volatility is a measure of risk in financial markets. It estimates how far prices are
expected to move in a given time frame. The VIX is an expectation or forecast of
the markets perception of risk in capital market in India

VXI provides investors with a measure of equity market sentiment on the relevant
stock indices ( NIFTY, SENSEX)
o When volatility is low, there is a measure of complacency evident in the markets;
lack of fear.
o High volatility, however, suggests a fearful market.
[3]

b) VIX enables investors to monitor this “sentiment” forecast on a daily basis.

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 IAI SA7-1120
VIX can also be used as a country/political risk measure

o The differenceetween the VIX and US S&P 500 VIX approximates the equity
market “fear premium” between an emerging market and a first world equivalent
- High risk differentials are associated with weak INR/USD
VIX is useful as a timing tool or directional indicator
o Spikes in the VIX are accompanied by troughs in the NIFTY50 (signalling a buying
opportunity)
o However, although the NIFTY50 typically rallies after sharp upward moves in
implied volatility, low levels of the VIX do not imply a weaker NIFTY50 market

The VIX Future enables volatility to be traded as a separate asset class

o VIX futures are negatively correlated with the NIFTY
o Consequently they can be used as a hedge against equity market falls
o Studies show the benefit of combining volatility and equities to manage
downside risk
Volatility futures can provide an alternative hedging instrument to put options based
on their relative value (for a given implied volatility term structure)
[3]
[42 Marks]

Solution 2:
i) The behaviors exhibited are
a)
 Anchor and adjustment – Has view about stock and continues to hold view even
where news outlook is negative.
 Confirmation bias – look for evidence to confirm their views even though the market
says something different
 Regret aversion – by retaining the existing arrangement will not suffer from regret if
they sell share and the value actually goes up rather than down
 Status Quo bias – people have preference to keep things as they are [2]

b)
 Confirmation bias – looks for evidence that confirms their point of view
 Anchor and adjustment – has pre-defined idea of stock, it is favourite company, so
doesn’t matter what people say they will continue to believe it will do well. [2]

c)
 Anchor and adjustment – has view of stock and uses past performance to make
judgement. View on growth is anchored on past performance
 Overconfidence – investor overconfident in their ability to predict future cashflows
 Availability – easier to imagine future returns based on past experience [2]

d)
 Framing – although the actual expected return of the alternative bond is higher the
investor has framed the decision in such a way as to make the alternative bond seem
poor value even though it offers the better return.
 Regret aversion – if hold the alternative investment and the return actual is 0% will
regret not holding the guarantee return.
 Risk adverse/myopic loss aversion – prefers to hold a guarantee return as places
more weight on the downside return of the alternative investment rather than the
upside
 Representative Heuristics – by having a guarantee return they place a higher value
than an alternative that involves chance. By adding further probabilities into the
scenario the return profile becomes more difficult to understand
[2]

Page 6 of 9
 IAI SA7-1120
ii) a) Two example of prescriptive regulations
 The investment in Mutual Funds AT ANY POINT OF TIME shall not exceed 50%*
of Investment falling under “Other than Approved Investments” for both Life and
General Insurance Companies
 Companies whose preference shares are selected for investment; dividend should
have been paid on equity shares for two years out of immediately preceding three
years.
[Any other regulations is also ok] [2]

b)
Advantages
 They are open to less abuse
 They give more public confidence
Disadvantage

 Cost of regulatory compliance becomes high

 there could be a trade off in the returns that could be achieved due to such
regulations [4]

c) A minimum reserve requirement is a requirement to hold a certain percentage of

deposits in liquid assets (e.g. cash or treasury bills). This is necessary to ensure that a
bank that accepts deposits will be able to meet demands for withdrawals from
depositors. This measure is generally considered necessary to provide depositors
with confidence in the banking system.

A risk-based capital requirement differs from the above by requiring a bank to have
capital support to cover a risk- based measure of its assets (loans and deposits with
other institutions). This is different to the solvency requirement of ensuring assets
exceed liabilities, which would also need to be met. [3]

d) A non risk-based capital measure such as solvency would be successful in ensuring

that assets exceed liabilities, however this ignores the complexities of valuing a
portfolio of loans.

Loans will either be paid back at the level set out in the documentation, or they will
default.

In the majority of scenarios, a loan would be paid in full. However, in a significant

number of scenarios, the proceeds from the loan (which is an asset of the bank) will
be much less than this.

If there is no penalty for risk in the capital measure, then a bank will have an incentive
to write a larger proportion of lower quality (but higher expected profit) loans within
its loan book to maximise its expected profits for a given amount of capital deployed.

As banks are a key part of financial system, involved in both payments and deposit-
taking, it is generally accepted that a risk-based capital measure is preferable.
[5]
[22 Marks]

Solution 3:
i) The acquisition might be a good use of cash because

 Lead Life is taking greater control of the distribution of its products to market.

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 IAI SA7-1120
 Keeping a significant cash balance may make Lead Life a takeover target itself
 Lead Life could return its cash to its stockholders through a dividend payment.
 Therefore, the acquisition is sensible if Lead Life can obtain a better return with this
investment
 Merging the companies may bring efficiencies through co-ordination and
administration.
 Areas where efficiencies may be sought are in:
IT , Finance and Accounting, Legal services and Compliance , Marketing, where the
merger is likely seek to reinforce a single brand and therefore will want to achieve
consistency..
 Lead Life may consider that the management of Aam Bazaar is poor and believes it
can manage the business more effectively given its knowledge of the target market.
 However, it may not be possible to replace the management wholesale
depending on the governance in place at Aam Bazaar.
 In reality, Lead Life management may be inexperienced in dealing with the issues
Aam Bazaar has faced and be unable to correct the perceived failings.
 Lead Life might be seeking to diversify away from being a principal to being a
service provider as well.
 However, stockholders may not be attracted to this aspect as they can achieve
diversification more easily through their own investment strategy.
 With larger scale, Lead Life may be able to achieve lower financing costs.
This would be achieved by offering larger volumes of securities. at a lower interest
rate due to the additional size of the company.
 However, lower financing costs are achieved because the two entities are now
guaranteeing each other’s debts.
 This leads to a lower risk premium in the valuation of debt securities.
 However, stockholders option to default has reduced in value.
 Issued bonds of Aam Bazaar will gain in value due to the lower perceived risk.
 This has been paid for by the stockholders in the new combined entity.
[1 mark for each – max 12] [12]

ii) The various strategies that can be adopted by Aam Bazaar are:-

 The Board of Aam Bazaar could change its charter so that only a portion of the Board
is able to be elected each year.
 Aam Bazaar could apply restricted voting rights to shareholders that own more than
a specified percentage of the stock.
 Aam Bazaar could decide to buy back the shares purchased by Lead Life at a higher
price than Lead Life paid under the stipulation that Lead Life does not pursue the bid.
 Aam Bazaar could require that a waiting period is enforced before any acquisition
can complete.
 The debt of Aam Bazaar could be structured to contain a clause that requires
immediate repayment of the debt if there is a hostile change of control.
 Existing shareholders can be issued rights that allow them to buy additional shares at
a low price if there is a significant purchase of shares by a hostile bidder.
 Aam Bazaar could acquire shares in Lead Life itself. This could allow Aam Bazaar to
try and block the transaction Lead Life is pursuing.
 It may also acquire assets that Lead Life doesn’t want or would be problematic, for
example if caused asset admissibility problems for solvency purposes.
 Aam Bazaar could look for a different purchaser or partner that it finds more
attractive. Such an entity is often referred to as a White Knight. The merged entity
would have an increased market capitalisation that would make it more expensive
for Lead Life to acquire.
 Lead Life may not want the business that the White Knight brought which would
make it less attractive.
[6]

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 IAI SA7-1120

iii) Share prices will be affected by:

 Market movements
 Markets evaluation of the deal – both for the return it will generate for Lead life
 Also the reading of the market w.r.t the price Lead Life is planning to pay
 Size of the transaction for Lead Life and thereby impact on its balance sheet
 Dividends it may loose out to pay its S/H
 Whether market sees the fit for the transaction
 If the transaction proves to be lengthy and taking time for regulatory approvals that
leads to value being destroyed
 Any tax complications
 Any arbitrage opportunities
[4]

iv)  Lead Life will need to construct a security whose income depends on the regular
commission streams it is receiving.
 The key factor in the level of commission that it receives on a block of business will
be the persistency of that business and the level of renewals.
 The company could structure the security as a multi-class security.
 The block of business to be securitized could be arranged by business type, for
example Lead Life and general business separately, where different persistency levels
are experienced.
 The most persistent business would be allocated to a tranche that was paid first.
 The number of classes would be dependent on the number of sensible homogenous
groups that could be constructed.
[Max 4]

v) And vi)

Cut back its activities Can lead to losing out customers

Look for alternative sources of capital like With the economy getting impacted due to
strategic investment COVID, the alternate source investments
take time to fructify
Evaluate each of the projects financed Incremental Returns generated may be
and choose which is most relevant to compromised
continue

Seek for injection of capital Shareholders / Stockholders may not be

keen
Take a higher investment risk to generate regulatory risk
some short term return

Look for another potential buyer Market reaction may not be positive and
thereby price may get impacted
Focus on core business Loose out to competition and perhaps

Advertising and marketing Loose out the position in the market which
may affect sales
[Max 5 + 5=10]
[36 Marks]

*********************

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 INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

26th November 2019

Subject SA7 – Investment and Finance
Time allowed: 3 Hours 15 Minutes (14.45 - 18.00 Hours)
Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions inside the cover page of answer booklet and instructions
to examinees sent along with hall ticket carefully and follow without exception.
2. The answers are expected to be India Specific application for the syllabus and
corresponding core reading. However, substantially the core reading material is still
taken from material supplied by Actuarial Education Company which is meant for
UK Fellowship examination. The core reading also contains some material which is
India Specific, mostly the IRDA regulation. In view of this, it should be noted that
focal point of answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the candidate
should answer the question with reference to Indian environment.
3. Attempt all questions, beginning your answer to each question on a separate sheet.
4. Mark allocations are shown in brackets.
5. Please check if you have received complete Question Paper and no page is missing.
If so, kindly get new set of Question Paper from the Invigilator.

AT THE END OF THE EXAMINATION

Please return your answer book and this question paper to the supervisor separately. You are not
allowed to carry the question paper in any form with you.
IAI SA7-1119

Q. 1) You are an investment consultant to a large university having a fund of close to USD 100
billion, has managed its investments using its internal resources thus far.
The stated primary objective of the fund is to ensure that the university will have the financial
resources to maintain its leading position in its market and contribute to society with first
class teaching, research and innovation for future generations.

The university is a strong believer in the ability to increase investment returns through active
management, promotion of good corporate governance and high social and environmental
standards. The fund at present uses a hybrid model of in-house and external fund managers.

The primary source of income for the fund is donations. The fund is growing due to donations
and investment income being in excess of current expenditure.

i) Describe the influence of the cash flow position of the fund on the investment strategy. (6)

ii) Discuss the characteristics of a benchmark which may be suitable for the fund, given its
primary objective. (8)

iii) Describe the active management styles “value” and “momentum”. (4)

The fund is considering an investment in infrastructure equity. You are asked to comment on
the advantages and disadvantages of managing this in-house compared to using an external
fund manager.

iv) Outline pros and cons of managing the infrastructure investments in-house. (10)

The Board of the university is considering potential agency issues between the University and
the internal investment team.

v) Describe the agency issues between the university and the internal investment team. (8)

vi) Suggest how these agency issues could be mitigated. (6)

[42]

Q. 2) You are an investment advisor. You get a new client who is 43 years old, Mumbai based HR
professional. He has steered clear of equity investment for the first decade after he started
earning. Instead he invested in what he considers tried and tested “fixed deposit” and “Public
Provident Fund”. He says “I have seen my parents rely on this, so I followed same. Also, I
don’t understand how the stock market works. It seems to me that it just keeps going up and
coming down”.

i) Describe 6 behavioural bias that has influenced his choices. (9)

ii) You have suggested the following product to him.

It’s a retail investment product issued by a well-known institution which guarantees a fixed 2%
over a 5-year period provided NIFTY is at or above its current level at the end of the period. If
the index falls below the current level, the investor will receive the return on the index over the
5-yr period.

Analyze this product from the investor perspective and include the likely underlying debt,
equity or derivative positions that the institution will be combined to achieve the guaranteed
return. (4)
[13]
Page 2 of 3
IAI SA7-1119
Q. 3) You are the CIO of a large Pension fund. The trustees have asked you to revisit the investment
policy specifically to include an objective towards Environmental, Social and Governance
(ESG).

i) Explain in simple words what does it mean to include an objective towards ESG? Include
in your explanation the impact it may have on portfolio return. (4)

ii) List the 4 critical questions to the trustees before putting together the policy? (2)

iii) In your report to them you have included example approaches to ESG like positive
screening and negative screening. Explain what do these terms mean? (4)

The trustees are interested in gaining an exposure to private equity, but have read about the
significant risk that is associated with such investment.

iv) Suggest an option strategy that would reduce the riskiness of the equity-based investments
and discuss the problems you may encounter in trying to apply it to the fund’s equity
exposure. (8)

The fund has a target investment in alternate investments of 15%.

You have received 2 proposals

v) First proposal has come to the fund to invest in a solar farm as a 30% partner, alongside
their 30% shareholding. The other 40% will be from a manufacturing company who will
supply the components of the solar panels. Shareholders will have to upfront 50%
development capital and rest will be bank loan amortized for 15 years. This proposal will
match exactly 15% of the fund’s alternate investment target.

Outline the process that should be followed to establish whether the investment is
appropriate for the fund. (12)

vi) There is online classified portal [Link] which was incepted 3 years back. This portal
has classified ads cutting across real estate to automobiles. It’s a platform for buyers and
sellers to meet. They have been invested into by HNI’s and one PE firm. Their business
plan outlays an ambitious plan to have several other verticals like housing, life insurance,
matrimonial and expansion pan-India. They have approached the fund for a 25% dilution.

Evaluate the merits and challenges of this second proposal? This would amount to 1% of
the fund’s alternate investment exposure. (5)

vii) The pension scheme is exposed to duration risk in that the duration of its asset portfolio is
shorter than the duration of its liabilities. It is trying to increase its interest rate exposure
for LDI / matching purposes and is considering three ways of achieving this:

1) To add a portfolio of pay floating / receive fixed swaps to the existing portfolio.
2) Investing more heavily in longer-dated gilts.
3) Buying a large futures position in the long gilt future.

Discuss the main advantages and disadvantages of the three options. (10)
[45]

****************

Page 3 of 3
Institute of Actuaries of India

Subject SA7-Investment and Finance

November 2019 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping
candidates. The solutions given are only indicative. It is realized that there could be
other points as valid answers and examiner have given credit for any alternative
approach or interpretation which they consider to be reasonable.
 IAI SA7-1119

Solution 1:
i) As donations and investment income are in excess of current expenditure, the cash flow
position is positive. [1]
There may be scope to reduce expenditure providing some flexibility to absorb
investment losses [½]
Cash inflows and outflows could be lumpy due to one-off large donations or capital
expenditure
[½, either inflows or outflows]
If the fund is expected to be cash flow positive for some time then it may be able to make
long-term investments, [1]
such as long dated infrastructure projects, [½]
or private equity. [½]
There is less need to sell assets early or be a forced seller to meet cash flow requirements [1]
allowing the fund to invest in less liquid opportunities [1]
There is less need to invest in income generating assets [1]
New cash flows can be used to rebalance the fund’s asset allocation [½]
and fund future new opportunities [½]
potentially without the need to sell other assets [½]
[Max. 6]

ii) The stated primary objective of the fund is not an explicit or guaranteed liability and is
more of an ambition [1]
Ideally the assets will at least need to grow sufficiently to match the increase in the cost
of providing the university services. [1]
A suitable benchmark may therefore be based on the cost of education, [1]
but as this is unlikely to be available the closest proxy may be some sort of inflation linked
benchmark. [1]
Depending upon the market there could be an inflation measure.
[½]
The benchmark could allow for a margin of outperformance, especially given the
potentially long-time horizon, higher risk appetite and belief in active management [1]
The benchmark could be set in line with the return objectives and amount of risk taken,
e.g. CPI + 4% [1]
The objective is a long-term ambition, so results over rolling periods or longer periods
may be suitable [1]
The chosen benchmark can also have a consideration that the constituent
stocks/companies in the benchmark adhere to ESG standards that is considered to be
appropriate by the management.
Some endowments may consider peer group benchmarks or a benchmark relative to an
equity index, but these may be less suitable as they do not address the objective of the
endowment [½]
[8]
iii) Value – focuses on purchasing shares that are relatively cheap or good “value” [1]
when considering factors such as Book to Price, [½]
Dividend Yield, [½]
Earnings Yield [½]
Cash Flow Yield [½]
and Sales to Price [½]
Momentum – purchasing (selling) those stocks which have recently risen (fallen)
significantly in price [1]
on the belief that they will continue to rise (fall) [1]
owing to an upward (downward) shift in their demand curves. [½]
[Max.4]
iv) Pros of managing the infrastructure investment in-house:
Page 2 of 9
 IAI SA7-1119

• Closer alignment of interests [1]

• Close monitoring and interaction possible [1]
• Potentially lower cost [1]
• Full control over investment [1]
• Ability to have more focussed portfolio (because of diversification with other assets,
less need to have a lot of diversification within the portfolio) [1]
• More flexibility to incorporate the endowment’s philosophy of active management
and ESG factors [1]
Cons of managing the infrastructure investment in-house:
• Potential requirement to hire additional specialist resource [1]
• Difficulty in attracting the most talented investors in this specialist area [1]
• Fixed costs of setting up new capability can be large [1]
• Less ability to diversify and pool with other investors [1]
• Access to infrastructure markets may be complex and require more experience
compared to investing in stocks and bonds [1]
• Infrastructure specific issues, including regulatory, legal and tax issues make
outsourcing to a specialist more attractive [1]
[Max. 10]

v) Agency risk is the risk that arises from the misalignment of interests between
stakeholders. [1]
When a principal hires an agent to work for him/her, the agent will not necessarily act in
the interests of the principal, and instead may act in their own interests. [1]
The existence of information asymmetry contributes to the potential occurrence of
agency issues. [1]
The internal investment team (as agent) may for example have an incentive to:
• Increase financial rewards for its senior management/staff
• Focus more on expansion of the team than cost control.
• Prioritise internal management of assets, instead of outsourcing which could be
more efficient from the university’s perspective
• Take too much risk, so to boost bonuses or status
• Focus too much on peer group performance
• Maintain the status quo, rather than adapt to meet the university’s needs
[6]
[Max.8]
vi) This issue can be managed and reduced somewhat by attempting to align the interests
of the principal and the agent. [1]
This could be done by having a variable pay element for staff or management of the
internal investment team based on performance. [1]
Variable pay could be deferred [½]
The principal could employ another party to oversee the internal investment team and
verify that they are acting in the principal’s interest. [1]
However, this usually adds an extra dimension to the principal-agent problem. [1]
Having a clear benchmark or financial objective, [½]
that takes into account risk taken and is being monitored closely [1]
A process for requiring sign-off by an independent body or university representatives for
significant investments, staff number budgets and the decision to in-source or outsource [1]
The university could ensure greater oversight of the internal investment team through
representation on boards or committees [1]
[Max. 6]
[42 Marks]

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 IAI SA7-1119

Solution 2:
i) The behavioural bias he exhibits are
1. Oversimplification: This refers to the fact that complex decisions are often approached
by first simplifying the complexity down to few manageable issues. Once the issue has
been selected a decision is made just basis that.
2. By investing in just fixed deposits and PPF the investor here has exhibited to
oversimplifying the investments he has made. He has broken it to managing just f ew F.
D’s, PPF’s etc and then the decision to continue for last 10 years is basis that.
3. Status Quo bias: People tend to leave things as they are rather than
make radical changes. This often happens because people do not have
any narrative with which to base an alternate decision
4. Once the decision was made, he continued to remain invested in FD’s and PPF’s to
maintain status quo. He didn’t take any other decisions to change his status quo.
5. Confirmation bias: Investors tend to ignore that contradicts what they
believe and seek out information that confirms what they believe. This
reinforces the overconfidence that they have in their judgement.
6. To justify his decisions, he ignored the stock market returns and in
fact the statement made by him” stocks go up and down” is to provide
himself with the confirmation that his decision was right.
7. Conservatism bias: This bias suggests that people form a decision
based on the information at a certain time, but once the opinion is
formed, they are unlikely to change it based on new information.
8. He exhibited conservatism as he relied on what “his parents” invested
in” and once that opinion was formed, he didn’t move from that.
9. Illusion of control bias: This bias suggests humans feel that they have
more control over and are more responsible for the outcomes of the
situations than they actually do.
10. This is exhibited by him as he feels more in control with fixed deposits
and PPF’s and ignores any other investments.
11. Regret aversion bias: This is a tendency for people to avoid making a
decision or a change if there is a high fear of regretting it afterwards.
12. His statements reflect this tendency of not wanting to venture anything
which may lead to regret afterwards. [9]
ii) From the investor's perspective, the product seems to give a guaranteed
return compared to yields on risk-free bonds of a similar duration. Just
looking at the guarantee part, given that he is used to guaranteed rates
from PPF or FD’s, this would be a product which may find attractive.
There is no upside above the fixed return, so the investor will be exposed
to the risk of high inflation eroding the value of the future pay out.
However, this feature is akin to his current portfolio.
The main risk for the investor will be an equity risk, whereby a severe fall in the market will
cause the investor to lose much of the funds invested. This is what he fears the most.
However, it is a small way to start exploring investments into the equity market.
[2]
Underlying portfolio held by the institution
The institution is likely to begin to match the guarantee using a portfolio
of 5-year government bonds. Put options on the NIFTY total return index
could also be written by the institution for a cash lump sum. This lump
sum might then be used to buy a 5-year zero-coupon bond.
If the index falls below the current level, the put options will be exercised against the
institution, and would need to be paid for using funds from the portfolio. However, this

Page 4 of 9
 IAI SA7-1119

coincides with the scenario whereby the investors are expecting

their funds to be diminished
[2]
[4]
[13 Marks]

Solution 3:
i) Even though the primary function of institutional investments is to
generate investment return, the investment process doesn’t not exist
independently of the wider economy or society at large.
In simple words if the investment process is not carried out efficiently many
people and business sin wider economy and society will lose out. If the
investment policies do no respect peoples environmental and ethical wishes,
society may find that it is funding the very things it hopes to eliminate. “Any
institution exists for the sake of society and within a community”
In the recent years there has been an increase in expectations for
institutional investors with regard to the “wider impact”.
[2]
There are various views on the impact of ESG on portfolio. One perspective
is applying ESG constraints will lead to reduction of potential investment
return because of the smaller universe is likely to result in compromised
performance compared to an unconstrained, larger universe.
Another perspective is that selecting companies with strong ESG credentials
tilts the portfolio towards companies which may be more successful in future
and therefore ESG acts as a filter to identify future profitable enterprise.
[2]
[4]
ii) The critical questions to be asked are
What is the impact on the expected level of investment
return? What are the risks associated with the policy?
How will the policy be implemented?
Is the policy properly documented?
[2]
iii) Negative screening means avoiding companies that fail an ESG test. The
exclusion from a fund or plan of certain sectors or companies involved in
activities deemed unacceptable or controversial. If a firm’s practices run counter
to the fund’s values, then it is screened out of the investment portfolio. It’s like a
boycott, but with investment capital. For example, a strong view on
environmental factors may remove fossil fuel producers and heavy industry from
its eligible universe. This is referred to as negative screening,
Whereas Positive screening means buying companies that pass a hurdle or test.
Investment in sectors, companies or projects selected for positive ESG performance
relative to industry peers. For e.g. bonds that fund key infrastructure development in
key social areas (such as hospitals) may be actively purchased.
[4]
iv) The simplest strategy would be to buy a protective put by buying put options. These
could be at- the-money or out-the-money options depending on how much downside
protection the investor required. The amount of options to be purchased would equal
the value of the portfolio to be hedged. It would be possible to buy such options based
on a representative equity index. [1]
If the value of the equity market falls, then the holder of the put option has the option
to sell the underlying at the strike price and hence recoup the losses suffered in the
portfolio. [½]
Private equity
Page 5 of 9
 IAI SA7-1119

The main problem with using such a strategy for a private equity portfolio would be the
lack of correlation between movements in the equity index and movements in private
equity portfolio values. [1]
This is called cross-hedging risk. Although the private equity market is linked to the equity
market, it could react to changing economic conditions in a completely different manner. [1]
Another problem is the difficulty in obtaining private equity portfolio values. These can
only be accurately valued at the wind-up of a fund. Thus, it would be difficult to monitor
the effectiveness of the hedge. [1]
It would also be virtually impossible to manufacture an over the counter put option
based on a notional private equity portfolio because such portfolio valuations are
subjective. [1]
A further problem is related to the term of the investment. Private equity funds typically
last for 10 years or more, and any hedging strategy would have to exist for this long in
order to be effective. This would require a great deal of rolling over if traded options
were used or would require a very long over-the-counter option to be written, which
may not exist or may be expensive to create. [1]
The fund may also encounter regulatory or other restrictions in implementing such a
strategy. [½]
There would be significant other costs in such a strategy such as broker fees and
transaction costs. [½]
There may be significant operational risk and credit risk if over-the-counter options were
used. [½]
[8]
v) This type of investment requires a great deal of due diligence as it is will be one large
investment covering 15% of the portfolio. [1]
The due diligence process should cover the following:
Return expectation
Corporate financial analysis to place a value on expected income stream
Estimated energy generation and likely future energy prices.
Sensitivity and Scenario analysis to understand the value of business
Due diligence of the owners and any third party.
Tax analysis to understand if any tax implications [2]
Investment characteristics
Impact on fund’s risk level and expected return
Marketability of such investments tends to be low. From a future valuation point of
view also it could be tricky to find any suitable measures to value such investment
Would the Pension fund require an annual valuation? If so, is there any
expertise in house or external available?
Liquidity of such investments – both in terms of any future investment
And Impact of any upgrade. Liquidity of such investments would be
very low. However, given that it is for a Pension fund, where liability is
long term, this may be not be a big risk
Views/ any mandates on whether Pension fund can participate in such transactions
Particularly with respect to risk/return profile from funds perspective
Whether income stream is correlated with the pension fund liability
(e.g. inflation linked)
[2.5]
Legal review

Legal review of agreements governing the ownership of the solar farm and associate
rights [1.5]

Page 6 of 9
 IAI SA7-1119

Legal review of the electricity supply, purchase and support agreements.

Legal review if bank lending agreements, including covenants.

Management aspects
Fund will need to carefully consider how its interest are represented.
Active management could be a constraint. Given it has 30% shareholding but
whether any voting rights are provided. Is there any board seat being offered?
The fund will want to understand the sponsor's management style and
commitment to the project over the long-term. The manufacturing
company holds 40%. What will happen post the construction phase?
Especially important for the fund to review any scenario where the
control is sold to some other third party
The fund would want to understand if there are any conflicts of interest
Also, if the fund is likely to want the options of selling its interest
[2]
Diversification

There could be diversification benefits provided with other assets held

by Pension fund e.g. equity, bonds etc. However, this investment would
fully utilize the fund investment target in alternate investments of 15%.
Is that being reviewed? Would the board prefer to spread the alternate investments in
couple of more investments?
[1]
Competition
Likely aggressive competition given that this is a growing space. Moreover, the
competition is expected to be sophisticated. Those with deeper pockets are likely to
compete hard. A lot would also depend upon how the competition plays out in the
distribution of the energy.
[1]
Regulations and Pricing
Given this is a sunrise industry, are there any regulations? A lot will be dependent on
the Government’s focus on such initiatives. Hence any regulations enabling such
alternate power generation will be critical. A flipside could also be if there are any
stringent regulations / curbs placed on pricing of the energy prices in future.
[1]
vi) The key difference in reviewing this proposal to the previous one is that this will cover
only 1% of the investment. Though the due diligence work is important,
but the fund can take a more aggressive approach to the investment. [½]
Here the company “[Link]” is a startup which is in expansion
mode. Nothing much is given about the revenue being generated.
Hence the investment here is to be purely seen as a VC approach where the fund could
look at early investment and an exit in medium term if the valuations are ripe.
[1]
The key question to answer here would be does that meet the investment philosophy
of the fund? [½]
The other key areas that would merit consideration are: - [3]
Board/Management quality of “[Link]” –
o Do they have industry experts and technology exports with them?
o How well do they understand the dynamics and buyer/seller
sentiments for the other verticals segment?
o There are merits of diversifying into different verticals, but do
they have experts to manage each of them?

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 IAI SA7-1119

Market Growth Prospects

o The model of connecting buyers/sellers is gaining appeal
amongst the younger generation

New regulations
o Any regulation threat as currently such business is largely unregulated.

Product/Service Quality
o What is the process adopted by this portal to secure the transaction?
How well the portal manages to match the needs of potential buyer’s
basis parameters such as the ones stated above. Are there any user
feedback ratings that can also indicate how good their service is? Have
they been consistent in providing good service standards across time?

Input Costs:
o These are primarily technology driven. Technology costs comprise of both fixed
and variable – arguably the former would be the heavier component. The fixed
costs in turn would get averaged out across the various sales transactions
– hence depending upon the average number of sales transactions
concluded through [Link] the break-even point would get influenced.’

Retained Profits
o Likely not very high since these companies have heavy
overheads and longer break-even terms.
o However, the size of the parent/investor pockets can be a suitable proxy to
gauge the level of risk appetite and potential market aggression.

[5]
vii) Swap Portfolio Longer dated Gilts Long gilt future

- There is a + The yield on gilts could - There would be a

counterparty risk in be higher in places than substantial margin
a swap. This can be the yield on a swap, requirement for such
reduced by margin therefore there is a yield a large futures
or by central position which may
advantage.
clearing, but it still is result in cashflow
a potential problem. problems.
+ Flexible in term. The - There is a limited - The gilt future has a
scheme can accurately number of ultra- term of 10 years
design the exact spread longs. The scheme (similar in other
of durations for the swap may find it is heavily countries) and may
portfolio that it wants. exposed to these not respond to
specific issues. changes in interest
rates at longer
durations.
- Swaps are illiquid and - There is increased - The future would
may cause operation exposure to the need to be rolled over
or valuation problems government which indefinitely, which
in the future. would make the would cause basis risk
scheme vulnerable to and incur costs.
a rating downgrade.

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IAI SA7-1119

- A large swap portfolio - The term of ultra- + This would be quick and
may cause problems longs may still be less easy to put in place, but
in the future if the than required. Swaps there may be capacity
scheme is split are available at longer constraints if the scheme
through mergers or durations. has a large position.
acquisition activity.

[1
each
pt.]
[Max
. 10]
[45
Marks
]

*********************
Page 9 of 9
INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

25th June 2019

Subject SA7 – Investment and Finance
Time allowed: 3 Hours 15 Minutes (14.45 - 18.00 Hours)
Total Marks: 100

INSTRUCTIONS TO THE CANDIDATES

1. Please read the instructions inside the cover page of answer booklet and
instructions to examinees sent along with hall ticket carefully and follow
without exception.
2. The answers are expected to be India Specific application for the syllabus
and corresponding core reading. However, substantially the core reading
material is still taken from material supplied by Actuarial Education
Company which is meant for UK Fellowship examination. The core
reading also contains some material which is India Specific, mostly the
IRDA regulation. In view of this, it should be noted that focal point of
answers is expected to be India Specific application. However, if
application specific to any other country is quoted in the answer the
candidate should answer the question with reference to Indian
environment.
3. Attempt all questions, beginning your answer to each question on a
separate sheet.
4. Mark allocations are shown in brackets.
5. Please check if you have received complete Question Paper and no page is
missing. If so, kindly get new set of Question Paper from the Invigilator.

AT THE END OF THE EXAMINATION

Please return your answer book and this question paper to the supervisor separately. You
are not allowed to carry the question paper in any form with you.
 IAI SA7 - 0619

Q. 1) You are an investment consultant working in a large actuarial consulting firm. X Ltd is in the
property broking business. It is the owner of a popular portal called “[Link]” that connects
potential buyers of property with sellers, effectively acting as a sales intermediary and earning
commissions for the transaction. They work across the spectrum of new projects (ready for sale
and under construction) and existing projects (resale properties). The average commission rate
is 3.0% of the total transaction value. The market where X Ltd operates has many e-commerce
players joining the fray in the recent past. The focus is more on primary property sales (from
builders to first time owners).

The success of X Ltd. has been its strong focus across both important phases of the property
transaction value chain viz., matchmaking (connecting the right buyer to the right seller) and
fulfillment of the potential match (covering discussions with the builder/developer, loan
support and help with legal/paperwork etc.)

For projects that are “under-construction” and sold by big builders promising delivery in the
foreseeable future (usually 2 – 3 years’ time), the payment for the concluded transaction
between a registered valid buyer and registered valid seller usually happens in tranches. The
builders book the flats in the name of the registered buyer based on a token advance amount
(varying between INR 1 lakh to INR 5 lakhs depending upon the nature of the project).

The payment to X Ltd, in turn, begins with the first token payment made by the buyer to the
seller and thereafter every time a tranche of payment is released (usually linked to progress as
per the agreed construction plan). Usually the buyers, in turn, get financing from a home finance
company (NBFC) or a bank specializing in mortgages). Note that X Ltd. has various tie-ups
with top rated banks and home financing institutions, and they help the buyers to connect with
the loan providers as part of their process.

X Ltd. is funded by PE funds and high net worth individuals, mostly incorporated in the USA.
X Ltd is presently unlisted in the Indian stock market.

However, over the past 2 years, things have been less attractive – for both the company and the
industry.

In recent years, the Board of X Ltd. has got concerned over the differences between projected
revenue (based on the order book of closed transactions) and actual revenue realizations that
occurred subsequently. The valuation of the company has, in turn, got impacted negatively.

i) The Board has sought your advice to on the Company’s fair market value. Discuss the
various factors you would consider – both qualitative and quantitative – in valuing the
company. Also highlight potential risks that are present in the business model above.
Your answer should include general aspects of valuation of the Company and a specific
focus on potential risk factors that can impact the valuation negatively. (25)

[Hint: Do consider the impact of recent events where project delivery was impacted. Also
consider impact of key Regulations (as applicable) within the factors above.]

ii) Briefly describe three keys concepts that can be used as a framework to analyze human
behavior in the context of investment psychology. (3)

iii) In your view, how does each one of the above affect the Property developers/sellers and
potential homeowners/ buyers – mainly middle class and investor class (e.g. NRIs) in
your view - would it be beneficial or otherwise to them? (8)

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 IAI SA7 - 0619

iv) Many of the reputed builders that are part on [Link] are listed. You have been invited
by another client within your consultancy firm, Y Ltd., which is a top-rated mutual fund.
They have a specialized property fund. They have asked for a presentation from you
covering the following aspects.

a) Define the Efficient Market Hypothesis (EMH) and describe what this implies in
terms of active versus passive investment management styles. (3)

b) What deficiencies can be spotted with respect to EMH narrative? (8)

c) The Group CIO wishes to create a framework to identify managers within his team
who are likely to be successful as against those who are unlikely to be successful.
This is more like an early warning system so that they can help the likely unsuccessful
ones to fill the gaps where necessary. They request your assistance in defining certain
aspects that could differentiate likely successful and unsuccessful managers. (8)
[55]

Q. 2) i) What are the key risks that banks face and how are these managed? (9)

ii) List the types of bank capital that fall into each of the three tiers typically set by the
regulators. (3)

Thirteen state banks have reported combined losses of $8.6 billion for the year to March -
including $6.5 billion in the last quarter. Assets that bank in the country have used as collaterals
have fallen sharply and many of the loans are non-performing. The non-performing loans have
surged nearly a fifth from end-December levels.

iii) There could be a situation where 5 of the banks may potentially go bust and will not be
able to survive for a long time. Discuss the following alternatives that can be taken up by
the Central Bank :

a) Introduce with immediate effect, a limit on the funds that can be withdrawn on any
day from the banking system as cash withdrawal.

b) Act as a lender of last resort, whereby the central bank would lend money directly to
the failing banks in order to allow them to finance their accruing liabilities. This may
require printing money if demands from bank is very high.

c) Allow the 5 banks to collapse.

Discuss the pros and cons of each solution form the perspective of the central bank and
the tax payers of the country. (12)

iv) Central bank has announced a bailout.

You are of the opinion that the reason for the number of banks being bailed out is that
the market participants did not consider the risks qualitatively in order to see the
significant risks that lay ahead and that these risks were not being properly assessed.

Your friend is of the opinion that the cause was a failing in the quantitative measurement
of risk in the risk models that the banks have been using. Further better models and more
relevant data would have prevented the crisis from happening.

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 IAI SA7 - 0619

a) List three market participants who enable markets to operate and three who offer
services. (3)

b) Outline the merits and criticisms of your friend’s view. (4)

c) Outline the merits and criticism that your friend will offer for your view. (4)
[35]

Q. 3) A recent article argues that a market valuation of a privately owned Pharma company is
unaffected by its dividend policy. It goes on argue that since the investor’s desire for additional
cash can always be satisfied by selling an existing investment holding, investors will not pay a
higher price for shares of firms with high pay-outs.

i) Which theory does the article base its argument on? What are the major assumptions
underlying this theory? What are practical factors influencing dividend policy? (5)

At its recent year end the company decreased its annual dividend payment by 20%.

ii) Outline the possible reasons it may have done so? (5)
[10]

*************************

Page 4 of 4
 Institute of Actuaries of India

Subject SA7-Investment and Finance

June 2019 Examination

INDICATIVE SOLUTION

The indicative solution has been written by the Examiners with the aim of helping candidates.
The solutions given are only indicative. It is realized that there could be other points as valid
answers and examiner have given credit for any alternative approach or interpretation which
they consider to be reasonable.
IAI SA7-0619

Solution 1:

i) The key areas that would merit consideration are

1. Board/Management quality – various factors to be considered here

a. Do they have industry experts and technology exports with them? [½]
b. How much of Indian property market experience do they possess? How well do they
understand the dynamics and buyer/seller sentiments for the primary property
segment (where under-construction properties are sold)? [1]
c. Does the Board/Management possess similar expertise in other foreign markets?
Since it is a foreign PE fund does it have similar investments in online property broking.
[½]
d. What is the management’s view on the compliance issues plaguing the property
industry? Basis discussions with the management as part of the process of valuing the
Company this can be gauged to a reasonable extent. [½]
e. Track record of key executives within the Company and Board. [½]
[3]
2. Market Growth Prospects
a. Urban, Tier 1 and Tier 2 cities in India has a growing middle class which is also quite
computer savvy. Hence the demography is very supportive. [½]
b. Home ownership is a traditional value instilled in most middle/upper middle-class
segments of the Indian population - so demand for the business the Company operates
in is likely to be high. [½]
c. More and more players entering tech-enabled business – so the traditional model of
connecting buyers/sellers is losing appeal amongst the younger generation who are
earning well and are keen to buy their property as early as possible. [½]
d. Given that property has been a growing asset class in India – especially the past few
decades having witness substantial growth – the industry would continue to be
attractive and the competition is expected to be fierce. [1]
e. New regulations like RERA (Real Estate Regulation Act, 2016) have provided further
security and comfort to buyers – this in turn increases confidence of the buyers leading
to higher demand. Especially about the working-class home buyers, RERA has provided
a long sought-after relief. [½]
[3.5]
3. Competition
a. Likely aggressive competition given that this is a growing space.
b. Moreover, it is technology driven – and hence the competition is expected to be
sophisticated. Those with deeper pockets are likely to compete hard.
c. Regulations like RERA that has been recently launched has also instilled a great
amount of discipline in the competition – cutting off unhealthy practices that were not
in the best interests of the consumers or the industry.
d. Since brokers also require compulsory registration under RERA, and their activities can
be monitored/scrutinized, rogue and unscrupulous players would anyways be on the
decline.
e. Those with the best management team with the right skillsets across the value chain
of the sales process would likely perform better. [3]

4. Product/Service Quality:
a. What is the process adopted by this portal to secure the transaction? A good property
brokerage firm would typically play a role in each of the below areas:

Page 1 of 10
IAI SA7-0619

i. Matchmaking/Listing - between the available properties and the needs of the

registered buyer. Various factors such as location, size, budget, developer
credentials, neighbourhood etc. would have to be matched. Depending upon
how rich the data analytics capabilities are – the better that the portal would
manage to secure a proper match. This implies, inter-alia, the systems and
processes to enable such vast matchmaking to happen. So, the questions that
needs to be answered are how well the portal manages to match the needs of
potential buyer’s basis parameters such as the ones stated above. Are there
any user feedback ratings that can also indicate how good their service is?
Have they been consistent in providing good service standards across time?
ii. Fulfilment of the potential property – these would include site visits to ensure
that whatever was depicted online is a fair representation of reality. Does the
Company have specialized staff who can assist in the site visits?
iii. Loan capacity evaluation - Once the property/properties have been shortlisted
after site visits– the loan capacity evaluation also happens. The que
iv. Negotiation with the property developer builder – best prices, best location
within the project.
v. Legal formalities including assistance in paperwork completion. [3]
b. Do they have informative articles and research to help potential buyers understand
the market dynamics and help them make an informed decision? [1]

5. Input Costs:
a. These are primarily technology driven. The main costs are therefore the development
costs involved in this highly competitive e-commerce space.
b. Technology costs comprise of both fixed and variable – arguably the former would be
the heavier component. The fixed costs in turn would get averaged out across the
various sales transactions – hence depending upon the average number of sales
transactions concluded through [Link] (including any projected growth in the
same) the break-even point would get influenced.’
c. Also, amongst the employees involved on the technology side might have a few highly
paid resources. These are primarily costs involved in the “matchmaking” aspects and
the “Sale conclusion “aspects. [2]

6. Retained Profits
a. Likely not very high since these companied have heavy overheads and longer break-
even terms.
b. However, the size of the parent/investor pockets can be a suitable proxy to gauge the
level of risk appetite and potential market aggression. [1]
7. Risks
a. What if projects get delayed due to issues being faced by reputed builders. How would
the payment stream to X Ltd. be affected?
b. Delay in construction can cause delays in tranche payments and hence delays in
revenue realizations for [Link].
c. Compliance with regulations can further impact delivery – impacting revenue flows of
X ltd.
d. Some of the builders may face severe liquidity issues and shut down operations
temporarily.
e. Also, with recent government interventions like demonetization of high value currency
notes, property prices crashed dramatically leading to massive cancellations of

Page 2 of 10
IAI SA7-0619

bookings made by buyers (since the expected market value of the property has fallen
significantly and the mortgage value to property value ratio is close to 100%). [4]
8. History
a. The track record of the company measured in terms of customer satisfaction would
play a paramount role.
b. User reviews on the various aspects of the sale process – both matchmaking and
transaction closure – would help place a value on the brand [Link]
c. Also, how they have handled any potential crisis (like demonetizations etc.) would
become equally relevant.
[25]

ii) 3 parameters
Parameter Definition
Group Ego The difficulty of moving a narrative away from a popular or
accepted norm, because others in the group will have their egos
hurt, and others in the group will want to avoid hurting egos.
Conforming the tendency for people to confirm 2 an accepted narrative. This
can be enhanced by education, which normally teaches and
established method for analysis.
Herd like behaviour The tendency from groups to find comfort in adopting a common
belief or a common approach it revolves around the idea of
strength in numbers, and the benefit that it gives to the egos of
those in the group.

Alternatively, marks can also be awarded to

Nous : as 'mind', 'thought', 'forethought', 'imagination', 'intuition', 'reflection' and the 'mind's eye'
amongst others. We will use it to mean the way in which the individual views or perceives the
world.

Logos is translated as 'logic' or 'rational thinking'. It refers to the type of rational logic that could be
understood by all. The function of Logos is to condition the mental picture created by Nous.

Pyr is translated as 'fire', 'fire in the belly', 'animal spirits', or 'impulse'. It refers to the light and
energy used by the Psyche. [3]
iii)

Parameter Buyers Sellers

Group Ego - For both investor and middle - Given that middle class
class - invest in top builders who would rather invest in
have large projects (pay a homes by leveraging
premium). This should mostly be (mortgages) this Group
beneficial. [1/2] Ego narrative of buyers
- For middle class – buy properties would likely benefit the
in larger societies with amenities sellers a lot. [1/2]
(rather than builder floors). These - Use potentially lower
societies might not provide the quality plumbing,
best value for money sometimes flooring etc. since the
– depending upon that it may or buyers are more
may not be beneficial. [1/2] concerned on
- Given the strong belief that it is location/neighbourhood
okay to buy a home even via etc. and the other things
mortgage – it could become they will anyways
compulsive to buy a home on enhance it themselves.
Page 3 of 10
IAI SA7-0619

mortgage even though it might This narrative could

be financially the best decision. potentially damage the
[1] reputation of the builder
on the long run.
However, if all the
participants behave
similarly -then it results
in a disadvantage for the
market. [1/2]
Conforming - Home ownership is mandatory – - Attract buyers with
you must strive to buy your own celebrity advertising.
home – (narrative mainly -for These could prove costly
middle class). [1/2] and if there are any
- Houses are a -good asset class so subsequent project
invest in them given long term losses – then the
returns (mainly investor class) advertising cost would
[1/2] be dear! [1/2]
- This could potentially be good for
the buyer – if it is not very
leveraged (high proportion of
mortgage). Also, there could be
additional cashflow advantages
(including tax advantages) of
owning a property and renting it
out whilst staying at another
property. [1/2]
- Depending upon whether the
property is bought as an
investment or self-occupation –
the advantages of conforming
can differ. For self-occupation
there is a clear advantage in
conforming. For investor class –
depending upon future property
price movement – they may or
may not be successful. [1]
- Alternatively, a land investment
could be more beneficial than
property investment but given
the “Conforming aspects” [1/2]
Herd like - Property prices always are on the - The herd-like behaviour
behaviour/Market rise. [1/2] of buyers would only
Psychology - Potential Buyers would not defer benefit the sellers by
consumption - might simply take harping on the same.
a loan to fulfil their consumption. [1/2]
[1/2]
- Depending upon how the loan to
home value ratio moves – this
could be either detrimental or
beneficial to the buyer. [1/2]

Alternative solution of using Nous, Logos and Pyr is also be acceptable.

Page 4 of 10
IAI SA7-0619

[Max. Marks 8]

iv)

a) EMH – Asset prices fully reflect all available information. The consequence is that the
property stocks always trade at their fair value. This means it would be impossible to beat
the market consistently by picking individual stocks.

If EMH were to hold to a large degree – then people would not be willing to pay for
research since there would be no consistent or significant value in doing so. EMH would
support passive management overall as opposed to active management.

The number of trades and the cost of trading would consequently be lower if EMH were
to hold since investors cannot exploit outperform consistently over a long period in an
active manner. Trading volumes would remain low, therefore. [3]

b) Deficiencies in EMH narrative (book-work – point 4.2 of chapter 10 of SA 7).

a. Asset Prices do not reflect all available information
i. Amount of information enormous. Volume and complexity too much even for
a competitive self-aware investor.
ii. Scarcity of time and resources to take account of all market inputs.
iii. Consequently, limits placed on narratives.
iv. Dominance of herd-like behaviour likely limits amount of information fully
incorporated into market prices.
v. EMH argues that only a few well-informed investors are needed to bring
market price to fair value. In practice this has not been the case.
b. Investors are not rational
i. Rationalizations basis other’s narratives
ii. These are basis collective thinking resulting in herd-like behaviour.
iii. Rationalizing someone else’s narrative is not the same as being rational.
iv. Market participants are not fully engaging their Psyche (Nous and Logos
mainly)
c. EMH is a Group Ego defense mechanism
i. Various anomalies have been shown to exist – these invalidate EMH.
ii. However, group ego defense mechanisms play it down since the anomalies
are analyzed within the narrative of EMH.
iii. One can argue that EMH is a justification of average investment performance
– sought by those who feel good sticking to a poor-quality narrative.
iv. Lot of psychological feel good benefits for narratives played out over a long
period. The Group Ego defense mechanism is a way of protecting the un-
competitive or lazy investor to explain his performance.
d. Investors with market power
i. EMH ignores players with market power. These people can significantly
influence the outcomes of the price.
ii. They can effectively bully other investors.
iii. Unlevel playing field since few players have disproportionately higher power
than others. This makes it unlikely that the prices would trade at fair value.16
[8]

Page 5 of 10
IAI SA7-0619

c) Possible Framework

Likely Successful Likely Unsuccessful – early warnings for course

correction

Understands the implication of opposing does not properly understand rival theories
theories. example EMH etc.

exercises patience and humility is mostly impatient and overconfident

considers it essential to have a disciplined wants to try to get rich quickly and without
psychological approach to investing discipline

actively and critically looks at the world and Creates a cynical narrative of the world
creates a critical narrative off it in a sceptical
manner.

create deep narratives talking when looking for creates shallow narratives when looking for
causes and effects causes and effects

sees a necessity to dig deeper behind media Missy news on face value or in the context of
narratives; is sceptical of face values conspiracy theories

when creating their own narrative want this to when creating their own narrative, may suffer
be as realistic as possible; questions existing from distortions, dismisses existing narratives in
narratives in a progressive manner to improve an overly negative way
understanding

are disciplined with their losses have little discipline with their losses

continue to learn to improve their narratives continue to add unjustified or unverified ideas to
their narratives

ability to persist and start over again try to learn ability to persist and start over again but they
from their mistakes usually don't learn from their mistakes

understand the advantages and disadvantages does not have a good understanding of
of diversification probability and statistics

[8]
[55 Marks]
Solution 2:
i)

There are three key banking risks

Credit risk - the risk that loans are not repaid
Liquidity risk- the risk that customers do not act independently but panic and want their
money back at the same time
Margin risk- the risk that the rate paid for short-term deposits varies while the rate
charged on long-term lending remains fixed. [3]
Managing credit risk

This is a two-stage process. First banks need to recognize that some loans will not be repaid.
This is done by generating credit scoring models that predict whether an individual loan will
be repaid based on experience of similar loans. i.e. underwrite the loan.
Page 6 of 10
IAI SA7-0619

Past claims are recorded along with customer characteristics to see which characteristics
correlate to higher credit losses. Now a days there are data models which helps predict the
customer delinquency.

The second stage to manage credit risk is recognizing that credit losses fluctuate significantly
through time. While banks can try and predict an average rate, recessions, increases in
unemployment or collapses in house prices can trigger much larger losses whose severity and
timing are unknown. [2]

Managing liquidity risk

Banks could remove liquidity risk by matching the duration of assets and liabilities, but this
would also remove their main source of profit from borrowing short and lending long.
Managing this risk is difficult as it is effectively related to confidence. If customers are
confident the bank is sound, they are unlikely to all want their money back at the same time,
but if they are worried, they demand their deposits back at the same time and the subsequent
bank run will destroy any bank.
Banks can ensure they are so well managed that there is minimal risk of a loss of confidence.
Part of this would involve holding (much) higher levels of capital. Another part would be
holding excess liquidity. Banks can also hold a so-called 'liquidity buffer'. This is a pool of
highly liquid assets that can be sold quickly to realise cash in case of a bank run. [2]
Managing margin risk

Banks borrow short-term money and offer savers the prevalent market interest rates (often
related to the central bank's base rate). However, they lend out longer term, perhaps in the form
of fixed-rate mortgages that make it hard to re-price the rates for borrowing customers to match
changes in the rates paid for deposits.

This temporal variation creates a significant risk for banks. Banks can mitigate this risk to a certain
extent by undertaking 'pay fixed, receive floating' swaps. If floating rates rise, and the interest
rate on bank deposits rises, then the swap will become valuable. This should offset the fact that
the mortgage asset, which has a fixed rate, does not reprice to the higher interest rates whereas
the bank deposit cost will rise for the bank. [2]
Note: Solutions covering Operational, Market, Maturity transformation risks etc. are also acceptable.
[9]
ii)
Tiers of capital

The following table describes the forms of capital and where each would be categorised:

Tier 1 Share Capital (equity)

Disclosed reserves

Hidden reserves

Tier2 Unrealised gains on investment securities Medium to

long-term subordinated debt

Tier 3 Short-term subordinated debt

[3]

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IAI SA7-0619

iii)
a. Limit on cash withdrawal

Such a limit would save the five banks from a liquidity crisis, in that they should be able to provide the
amount of cash needed on a daily basis.
However, investors and depositors would be queuing every day in front of cash machines to withdraw
the maximum cash amount. This has a negative impact on confidence and can lose many hours of
productivity over a very long period.
The crisis may not resolve itself in the short term, and the limit may stay in place for years.
Depositors in other banks would be penalised even if their banks are safe.
The economy depends on cash for certain activities (e.g. small-scale shopping, restaurant and drinks
industry, certain building trades). These may see a knock-on crisis if cash is limited.
If the limit avoids central bank loans, it will avoid the taxpayer being put at risk in the crisis.
Depositors will think hard about where to place their cash in future, so moral hazard is reduced.
If the banks have overseas subsidiaries it would not be possible to impose the cash ban in the other
countries. This would allow overseas depositors to get out of the banks, when domestic depositors
cannot. [4]

b. Act as lender of last resort

This would involve giving unsecured loans to the banks that are in danger of collapse. It has the benefit
that it would provide liquidity for the banks to continue trading and provide cash for those customers
that wish to withdraw capital.
Depending on the sizes of the banks, the amount of lending required could be extremely large.
Any central bank bail-out produces a moral hazard whereby the investing public believe that there is
no risk to their capital, and do not make the risk/return assessment required before placing their funds
with a bank. This favours the bank that offers the highest rate on deposits, even if it is a risky enterprise.
If the public learn that such bailouts are occurring, a run on the banks concerned would be inevitable
as investors move money to solvent banks 'just in case'.
This would make it impossible to support the five banks indefinitely.
It avoids a domino effect, whereby lack of confidence in the three struggling banks undermines
confidence in the whole banking system. This could produce a run on all commercial banks.
The collapse of the banks could cause severe recession in the general economy, leading to the collapse
of the other banks and the collapse of many non-banking entities. Lender of last resort could avoid this
disaster scenario.
Ultimately the taxpayer is paying for the rescue of some investors who chose the wrong
investment. This is unfair to the investors who chose the right investment and undermines the
capitalist system of economics. [4]
c. Allow collapse
The taxpayer is insulated from the bad decisions of the depositors in the failing banks.
So long as the five banks do not represent a significant part of the banking sector, the other banks
should in time be able to buy the remaining business from the failing banks at reasonable prices.
Depositors in the failing banks are very unlikely to lose all their deposits.
The impact on confidence could spark a larger crisis in the economy and for the remaining banks.
The central bank is not placed at risk, so ultimately it should be able to support the wider economy.
Under the other options, the risk that the central bank goes bust is a genuine one, which would
undermine the currency itself.
If banks make losses, they burn up capital resources. They could then breach international Basel
banking standards and be banned from certain other international economies, which would
further increase the chances of total collapse. [4]

[12]
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IAI SA7-0619

iv)
a. Three market participants who enable markets to operate
Dealers, market makers, traders, exchanges, clearing houses, custodians
Three who offer services
Investment analysts, fund managers, strategists, consultants, actuarial consultant, advisors.
[3]

b. The merits in friend’s view

Better models may have captured some of the risks that led to the banks going bust, which were
perhaps missed by the existing models.
Capital levels were based on the results of existing models, and capital buffers may have been
higher if the models had more accurately predicted the future risks.
If all banks used a variety of different models, then perhaps some models may have correctly
predicted the risks and others may not have predicted the risks, which is better than all banks
using a similar model to one another and therefore all being exposed to the same uncaptured
risks.
Criticisms of the Friends view

The models were presumably the best that the banks could create at the time.
The only data that is available to calibrate the models would have been the past data, and the
events that caused the collapse may not have occurred in the past.
Overcomplicating models can have a negative effect whereby users assign a degree of confidence
to the results that is not warranted, and the model can become unstable due to the detail and
complexity involved. [4]
c. The merits of your views

Financial markets are driven by real world events, which are influenced by political decisions at
home and abroad, as well as economic and natural shocks that may originate at home or abroad.
It is arguably impossible for any quantitative measure to capture these human or unpredictable
events.
Markets move in cycles, and predicting the stage of the cycle, and when the cycle may end is a
matter of human judgement, which cannot be predicted by computer models.

Criticisms of your view

In most market circumstances, the past is a reasonable predictor of the future, therefore models
serve a purpose, and the better the model can be designed, the better information the bank will
receive.
Moving the emphasis to subjective and qualitative measures would introduce a lack of uniformity
into the banking system that would have a negative impact on competition, level playing fields. It
may significantly increase the risk of bankruptcy. [4]
[35 Marks]
Solution 3:
i) The theory being referred to is Dividend irrelevance theory

This theory holds that -in a perfect world without taxes, transaction costs or other market
imperfections - the market valuation of a company is unaffected by dividend policy. It is
argued that, since an investor's desire for additional cash could be satisfied by selling part of
an existing investment holding, investors will not pay a higher price for shares of firms with
high payouts.

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IAI SA7-0619

Equally, if a firm wished to increase its dividend payout but wished to alter neither its
investment nor its borrowing policy, then the extra dividends could only be paid if, at the
same time, new shares were issued and sold to new investors. In a perfect market, those
investors will only be willing to pay a price for shares that equalled their value. Since all real
aspects of the firm are unchanged, the value of the new shares issued must equal the value
of the dividend paid.
Assumption underlying the theory is Market is efficient and investors act rationally
Several practical factors are influential in setting dividend policy:
 Target dividend payout ratios.
A company may have an aim not to deviate too far from a certain level of payout. The level will vary
dependent upon factors such as the nature of the company's business, its age and size.
 Trends in long-run, sustainable earnings.
The company will wish to target a stable dividend policy that can be supported by its typical level of
operations. This means it is less likely to take account of short-term cashflow changes or extraordinary
profits in setting its regular dividends (although short- term positive cashflows may be reflected in one-
off special dividend payments).
 Administrative and processing costs.
These can form a significant portion of the cost for small dividend payments. This may mean that it is
not sensible to distribute a dividend.
 Impact of changes in dividends.
The company will consider the relative size of the dividend payment from one payment to the next -
big changes will lead to market comment.
 Wish to avoid future reductions in dividends.
These are generally viewed unfavourably by the market.
 The information content of dividend policy.
In countries where investors have little confidence in other sources of company information (e.g.
the quality of the accounts), great store will be placed on the dividends as an indication of the
company's true financial position. [5]

ii)

 Company’s profits have substantially decreased, and directors are not confident about the future
trend of profits. The current levels may not be sustainable.
 Some internal business / product failures which has made the directors cautious and hence they
prefer to set a lower expectation.
 There may be a market expectation that dividends may fall. This could be due to various reasons
and directors may want to maintain the expectations.
 It may be that the Pharma industry and hence competition has reduced as well. Directors may want
to use the opportunity to revise.
 Cash reserves may have dipped.
 It could be due to a long-term strategy to reduce dividends and use the cash for other investments.
 There could be taxation changes which means it is no longer attractive to pay-out dividends
 Any statutory restrictions which constraints the company to pay out. [5]
[10 Marks]

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